Hereâ€™s a quick quiz for retirement investors everywhere. Itâ€™s simple, consists of one question only, and the answer is straightforward as well.
Oh, and the answer matters â€” big time.
The question: Based on the performance data of the last 50 years, what are the rough odds that the U.S. stock market will perform better than non-U. S. stock markets over the next 12 months?
The answer, using data from stock market financial data company MSCI, is C: About 50%. Since 1970, when MSCI first began tracking the numbers, the MSCI US stock market index has beaten the MSCI â€œex-U. S.â€ index (i.e., everywhere else) 51% of the time: 26 out of 51 years.
And, obviously, the rest of the world index has beaten the U.S. the other 25 times.
(If 2020 carries on as it has so far, the U.S. figure will rise to 27 out of 52, or 52%.)
There are less data about emerging markets but the results are similar: Since MSCI began tracking EMs in 1987, the U.S. has done better in 17 years and emerging markets better in 15, or 53% of the time.
Given those odds, youâ€™d assume the average investor holds about half of their stock portfolio in non-U. S. stocks, right?
To see how far removed the average investor is from this simple allocation, look no further than the latest annual survey from investment giant Vanguard. As it does every year, Vanguard opens the books on its vast book of 5 million retail clients, showing how, on average, they invest. It may be the best single overview of the typical Main Street U.S. investor.
Among the various details, one thing sticks out like a sore thumb: Whatâ€™s known as â€œhome country bias.â€ That means the psychological bias among investors to keep most of their money in their national stock market.
The average U.S. stock portfolio is not 50% in U.S. stocks. Nor is it even 60%, which is very roughly what current market values would imply. Itâ€™s 81%. No, really.
The typical investor is keeping four-fifths of his or her stock market portfolio in U.S. stocks. And that figure is pretty constant from small investors to large: From those with investment accounts between $3,000 and $10,000 to those with more than $500,000.
Itâ€™s irrational. Itâ€™s so irrational that financial economists have a name for it, â€œthe home equity puzzle,â€ and have been trying to explain it rationally for 30 years. â€œThe home bias in equities has fascinated both financial economists and international macroeconomistsâ€ since at least the early 1990s, notes Kavous Ardalan, a professor of finance at Marist College, in a recent review of the topic. This home country bias runs against one of the central tenets of modern investment best practice: That you should hold as diversified a portfolio as possible.
Experts have offered various ideas, but none fully explain the bias. (Notably, the bias is the same overseas as well â€” residents of foreign countries invest most of their money in that countryâ€™s market.)
Haim Levy at Hebrew University in Jerusalem offers a simple explanation: Peer effect, also known as â€œKeeping Up With The Joneses.â€ When it comes down to it, we â€œbenchmarkâ€ our performance against the people around us. So our biggest worry isnâ€™t missing out on gains, but missing out on gains that our neighbors are making. (Presumably we donâ€™t mind missing out on profits so much either, so long as our neighbors miss out on them.)
A truly diversified global fund such as the iShares MSCI ACWI exchange-traded fund [ACWI], which tracks the All Country World Index (including developed and emerging markets), still holds 58% of its money in U.S. stocks. It really makes no logical sense to invest any more than that.
Personally, I tend to invest even more internationally than that. There are powerful arguments that international and emerging markets offer much better value than the U.S., especially after about 12 yearsâ€™ of U.S. outperformance. If I were going away to a desert island for five years, and had to set an asset allocation before I went, Iâ€™d put a third each in the U.S., international developed markets and emerging markets, and hope for the best.
But at the very minimum Iâ€™d go with history and bet 50/50.