A maxim of money management is that people should never put all their eggs in one investment basket. Investment portfolio diversity helps lower the risk that any one single company, trend or event could ruin your nest egg. Strangely, it’s a rule of thumb investors often overlook, especially when it comes to the risk factor of geography.
Numerous research studies have shown that, regardless of where one lives, investors have a significant bias towards investing in companies based in their home countries—a “home bias.” In the Philippines, which accounts for 0.1% of the value of a global equity indices, individual investors typically hold 99.5% of their portfolios in Philippine companies. Americans are 82% invested in domestic companies even though the US accounts for about 40% of the world’s equity value. The phenomenon is even more pronounced when it comes to fixed income investments.
People usually feel more comfortable when they invest close to home, in familiar names, and they may even know more about companies in their own backyard. In the past few years, home bias would have been good for American equity and fixed income investors, but horrible for Greeks, whose stock market has plummeted about 62% since 2011.
However, now that the US Federal Reserve (Fed) has begun to raise interest rates, investors should re-think any home biases they may have. This is because the Fed’s moves will likely lead to a shift in prices for equity and fixed income markets around the world. In the US, it could result in lower prices for bonds and an increase in volatility for equities as higher borrowing costs put downward pressure on the economy.
“US investors have, to a certain extent, been spoiled by having a local bond market that is one of the deepest and most liquid in the world,” says Brendan Murphy, Senior Portfolio Manager at Standish, an investment management firm focused on fixed income. “This ability to choose a wide array of US bonds, and the long-running bull market for US fixed income, may have put blinders on investors when it comes to looking abroad for diversification opportunities.”
Thanks to the financial crisis of 2008, many investors have only known a US economy with low interest rates. The last time the US raised rates was back in February 2006. But this changed on December 16th when the Fed raised its benchmark federal funds rate to between 0.25% and 0.5%, and indicated that “gradual increases” in rates are expected as economic conditions improve.
So what do rising rates mean for bond investors? For those currently holding bonds, it’s not necessarily good news as, at a basic level, the price of bonds has an inverse relationship with interest rates. For example, if an investor purchased a bond for a face value of $1,000 with a yield of 10 percent a year, an interest rate rise of 2% would result in reducing reduction in the price of their bond by $200. If you were buying at this level, it would represent a significant discount but for existing holders of that bond trying to sell, it would equate to a capital loss.
The upside is that foreign bond markets have the potential to offer marginally better returns with lower risk. “Many countries outside of the US are engaging in additional monetary stimulus—buying back bonds and cutting interest rates—which bodes well for bond investors,” says Murphy. “As such a smart global fixed income component can be an useful addition to investors’ portfolios.”
For example, Murphy notes the European Central Bank (ECB) has only just begun its economic stimulus program, also known as quantitative easing. And ECB President Mario Draghi recently indicated he is planning to cut interest rates—the opposite of what is happening in the US. In Australia, where interest rates are already higher than many other developed countries, a weakening economy may also lead to interest rates moving lower, leading to higher bond prices.
Yet any shift away from a home bias mentality will be challenging. US investors may have become too comfortable with the perception of US assets as a ‘safe haven’. At the same time, they may also feel that by moving out of the US, they’re taking on more risk.
Still, now that the Fed has begun raising rates, investors should take time to analyze how over-concentrated they are in their home market. The solution likely does not involve scouring the globe either. “There is a growing number of mutual funds that can provide investors with an inexpensive way to add diversification to their portfolios,” says Murphy. “However, in the case of bond funds, investors should look to see if the fund manager hedges investments back to US dollars.” This, he says, can act as a buffer against currency fluctuations to which you could be exposed if invested in foreign assets.
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