Foreign and Domestic Stocks in Today’s Portfolio
The extreme bear market has caused stock prices to fall more than the price of most other financial assets. Consequently, the percentage of your wealth in stocks is probably lower than it was before last fall. So you might be wondering whether the market crash indicates you should remix your portfolio to give equities the same weight they had before. Your answer could depend on whether the stocks are foreign or domestic.
In normal times a severe market decline can, paradoxically, make your portfolio too safe. Consider this extreme example: Imagine you put a small amount of your investments in safe government bonds and the rest in a stupendously risky stock that will either go way up or way down. Overall you have a tremendously risky portfolio.
Pretend, though, that a sudden market collapse completely wipes out the value of the risky stock so that you’re left with just the government bonds. Now your portfolio is practically risk-free — which isn’t necessarily a good thing.
Whenever the percentage of stocks in your portfolio decreases, you’re less affected by market swings. But stock markets reward intelligent risk taking, so with a lower percentage of your wealth in stocks, you should expect lower average returns over the long run. If these were normal times — that is, if you wanted to take the same level of market risk as you did before the crash — you’d want to sell some of your safe assets such as government bonds to buy stocks.
But these aren’t normal times. The market has experienced a variance shock, meaning the daily fluctuations in equity prices are greater now than they were six months ago. Obviously, these fluctuations increase the dangers of stock ownership, so even if today you own a lower percentage of domestic stocks than you did before the crash, you likely have more stock risk than you did before.
I suspect stock market gyrations are because of uncertainty over whether we’re headed into a depression and over how the new Obama administration will handle the economy. Once the market gets this figured out, fluctuations will probably return to normal, and you should consider upping the percentage of stocks in your portfolio to their previous level.
You might, however, want to permanently lower your investments in foreign stocks. The big benefit of investing in stocks from other countries is that they diversify your portfolio and so, theoretically, reduce your exposure to potential market collapses. Until recently, most economists would have told you there was very little chance of the economies of every industrialized nation going into deep decline at the same time.
But we now know that the fortunes of other nations’ financial markets are highly correlated to the extent that a plunge in the U.S. market can easily coincide with a plunge in the value of most other stock markets. Investors now can’t rely on foreign stocks to dampen their exposure to extreme bear markets.
So if you own foreign stocks, you’re probably taking on more risk than you thought. To better manage your risk, you might want to hold a smaller percentage of those stocks than you did six months ago.
James D. Miller is an associate professor of economics at Smith College in Northampton, Mass. His latest book is Singularity Rising: Surviving and Thriving in a Smarter, Richer and More Dangerous World (BenBella Books), on sale in October.