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Is the U.S. Vs. International Stock Allocation 80/20 Rule a Conspiracy?

Last updated by on 15 Comments

U.S. Versus International Stock Allocation

How much international stock exposure should you have?

It’s a great question. And I’ve been looking into my own foreign stock allocation lately.

In my research, I found Vanguard’s “Considerations for investing in non-U.S. equities” – an annual research report that looks in to the topic.

The report states that,

“Common advice recommended by most financial institutions is to allocate 80% into U.S. (domestic) stocks versus 20% into foreign stocks.”

Where did this “common advice” come from?

The reason often given is the “diversification benefit”, or the point at which any further allocation increase in foreign investments would not increase the diversification value.

Having 80% of all your assets in one country’s stocks is the peak of diversification?

I thought I’d take a common sense approach to the issue by looking at two key data points:

  1. U.S. GDP as a percent of the world’s GDP
  2. U.S. equity market cap as a percent of the world’s equity market cap.

I can’t see two more relevant data points than this as it pertains to stock allocation, but I am just a naive amateur. Here’s what I found…

Percentage of the World’s GDP from the U.S.

If you’re not sure what GDP is, it is the market value of all officially recognized final goods and services produced within a country in a given period. In other words, what the economy of a given country actually produced.

Why consider this? Stock values can go up and down. They can be overvalued and undervalued. But what a country actually produces is much less subjective.

If we’re going to truly diversify based on actual economic activity, it may make sense to base your domestic versus foreign investment on actual GDP data.

Given the 80/20 recommendation, we will go in to this assuming that the U.S. GDP is roughly 80% of the world’s GDP.

How do the ACTUAL #’s shake out?

The total annual GDP of the world is approximately $63 trillion.

Back of the napkin math here: 80% of $63 trillion = $50.4 trillion.

So the U.S. has a $50.4 trillion GDP, right?

Not so fast! Try $14.58 trillion, or about 29% of what one might expect, given the 80/20 recommendation.

It turns out that U.S. GDP as a percentage of world GDP is approximately only 23%. This number would indicate that perhaps the reverse allocation 20% U.S./80% international would be more appropriate than the opposite.

On top of that, the percentage of U.S. GDP versus the world GDP is only declining every year.

Check out this graph from Google Public data that shows U.S. versus world GDP numbers over the last 50 years:

The world has seen almost exponential GDP growth, while the U.S. has seen slower flat-line growth.

Curious.

How About U.S. Versus International Market Cap?

GDP is one thing. What about actual market cap value?

Market cap value is how much the total value of equities is actually worth. So this is a comparison of the share price value the publicly traded companies of the U.S. have produced as a percentage of total world share price value.

Let’s see what we come up with…

In the aforementioned Vanguard report, I found the following data point – “as of December 31, 2010, U.S. equities accounted for 42% of the global equity market”.

In other words, foreign equities accounted for a full 58% of the global equity market.

42% for the U.S. is certainly better than the 23% GDP number, but it’s still a far cry from the recommended 80% allocation. Heck, even the Vanguard Total World Stock Index fund has a 50% allocation in foreign stocks (vs. 45% U.S.).

It used to be as high as 70% as recently as the 1970’s (probably when the 80/20 meme was created), but it has dipped quite a bit. Here is the graphic breakdown (U.S. in blue, world in brown, black line = 50%):

US_versus_international_investment_allocation

Yet the 80/20 Rule Persists

At the end of the Vanguard study, despite looking at significant data that proved otherwise, Vanguard fell back on the 80% domestic (U.S.) to 20% foreign recommendation. Why? The “diversification benefit”.

The odd thing is, that they actually have a graph (figure 2b in their study) that shows the global market is actually less volatile than than the U.S. market alone. So investing more towards the 42/58 breakdown is less volatile, not more, as one may be led to believe.

Intuitively, this makes sense. Think of it this way. If you had a ton of stock in your company, would you want 80% of your net worth tied up in that stock? No, you’d be crazy! What if the company tanked, went under, or severely declined in value? You would probably realize that you needed to overcome your “homer” bias for your company’s stock because you know the company so well.

So why would you tie 80% of your net worth in to the U.S. economy by having a “homer” bias for U.S. stocks?

Why not get out and diversify?

What about Foreign Vs. U.S. Stock Performance?

According to a study done by Ibbotson Associates, a global allocation beats a U.S. focused allocation over the long-term. $10,000 investment in a global portfolio in 1970 would have grown to about $500,000 in 2009 compared to about $410,000 only if invested in an U.S. S&P 500 portfolio.

That’s right, a global portfolio has historically beaten a U.S. focused portfolio, even over a period when the U.S. experienced vast economic growth.

My Conspiracy Theory View of the 80/20 Rule

My guess is that the 80/20 rule first became an investment meme at a time (most likely the 1970’s), when it might have actually made sense to have an 80/20 allocation based on total market cap and U.S. GDP vs. world levels. At that time, it was also expensive and difficult to find, research, and purchase international stocks. Today, that’s not even close to being representative of reality. So why has it persisted?

The U.S. financial sector needs it to persist. So they continue to tell us year after year “80/20, 80/2o”. And it’s worked!

At some point, it may have transitioned to a planned conspiracy. Think about it for a moment…

How do the large U.S. financial institutions make their money? Mostly by charging a percentage of total assets fee.

If U.S. investors were to realize that the 80/20 rule was outdated and move significantly more assets to foreign stocks it would mean the financial institutions would:

  1. see investors flee from U.S. stocks, driving the U.S. market cap down and many amateur investors out of the market entirely (which results in lower revenues/profits for them due to lower assets being managed).
  2. see their own share prices and net worth decline as a result of investors fleeing their own stocks and the market altogether and also as a result of lower revenues/profits.
  3. be forced to increase their operating costs as they would have to significantly boost their presence globally with analysts, research, etc., in order to stay competitive with their peers.

The 80/20 rule is safe for them.

I’m just not so sure it is safe for us.

Disclaimer: I am not a financial adviser, just a contrarian and a bit of a conspiracy theorist. You can draw your own conclusions on how much to allocate in international stocks.

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About the Author
I am G.E. Miller, & this is my story. My goal is financial independence ASAP. If you share that goal, join me & 7,500+ others by getting FREE email updates. You'll also find every post by category & every post in order.


15 Comments »
  • RMikes says:

    Good post- I like the proposition , and the theory makes sense.

  • Kevin@moneywisdomtips says:

    Quite professional.Love the details and precision.Nice post

  • Leah says:

    Well thought out! After a little ofmy own research, I might add some more international allocation for my next rebalancing.

  • Hector Avellaneda says:

    US GDP is declining more and more every year because we don’t produce anything. I challenge anyone reading this comment to go anywhere in your house, your closet maybe, and find anything that was made in the U.S and not in a foreign country.

    You make an excellent point in this article and I definitely agree that in our case the 80/20 rule should be implemented on the reverse side.

  • Pampibon says:

    You mention a quote from the report saying that the global market is less volatile than the U.S. market. Yet, I would think the environment/risk involved in the global market (or maybe I’m thinking more of emerging markets) are highter than in the U.S.
    Can you help me with that?
    Great post by the way! I’ll take another look at my retirement fund allocation.

  • Ginger says:

    I never thought having 80% in US stocks made sense. You don’t put more than 5-10% in a company you work for so you are diversified, wouldn’t the same idea apply on the international stage? I think People should reverse it and have 20% stocks in their own country and 80% international.

  • Con-man says:

    You did a great job summarizing the first 4 pages (of which, one is a cover page). I suspect you did actually read, but you were just using what helped to prove your point. If one were to actually read the Vanguard article, they would find some excellent (as usual) analysis. From the conclusion section where they actually recommend non-US holdings to be between 20% and 40% to be reasonable:

    “…that
    a 20% allocation may be a reasonable starting point.
    Although finance theory dictates that an upper asset
    allocation limit should be based on the global market
    capitalization for international equities (currently
    approximately 58%), we have demonstrated that
    international allocations exceeding 40% have not
    historically added significant additional diversification
    benefits, particularly accounting for costs”

    They found the diversification benefit to diminish beyond ~40%. Of course, this is using historical data, so who knows what the future holds…

  • Money Infant says:

    After reading your article it seems to me that the 80/20 rule is a perfect fit, as long as the 20% is your exposure to U.S. stocks. I’ve always wondered how an 80% allocation in one country could truly be called diversification and now I have my answer.

  • Ron Ablang says:

    My ICMA account only offers a few (less than 10) US-based funds while it only has 2 int’l funds. Unfortunately, the int’l funds don’t perform as well as the US-based ones, so I should stick w/ the 80/20 but I spread them evenly.

  • Mike O says:

    A very well done, thought-provoking analysis. I have more than 20% invested in foreign markets (but no where near 40%). I think that there’s a really good reason for most people to keep the vast majority of their investments in U.S. companies, though. (And, in fact, for anyone in any country to invest primarily in their own country.) Why? Because unless you’re willing to move abroad, your primary concern is growing wealth *in your own currency*, and at least parallel to your peers. Remember, diversification is about managing and spreading risk, and only secondarily about taking advantage of opportunities.

    Another one of the commenters compared the 80/20 domestic/foreign advice with the advice that people should never invest more than 10% in their own employer (and really, not more than 5% in any one investment). If you both work for a company and invest in it, you’re increasing your dependence on that single company and the risk that that company will severely impair your finances *relative to your peers*. 99+% of the country will not be working at that same company, so your finances will have gone down the tube, but the rest of the country will barely have noticed. Your relative wealth has spiraled, as has your buying power and ability to provide for yourself and your family — compared to everyone else around you. Additionally, you’re now working somewhere else.

    So there are two factors:
    1. Finances compared to peers
    2. Ability to leave “bankrupt company” (country in our case)

    Neither of these factors are true in domestic vs foreign investing. As a matter of fact, the opposite is true for most people. Let’s consider the two extreme cases to understand why this is dangerous. I know that neither one of these cases are terribly likely (world economies are too tightly knit), but you have to understand where you’re assigning risk.

    * Case 1: The finances of the U.S. fall apart relative to the rest of the world

    ** Let’s assume that you do invest 80-90% in foreign investments (the opposite of the traditional advice).

    In this case, you’re rich! You’re on top of the world and your finances are vastly improved compared to your peers (your countrymen). Most of the rest of the country is poor! Great! You can stay in the U.S., live well, and hopefully you’ll help out some of your peers (voluntarily, of course — what’s with government believing that spreading wealth under the threat of criminal prosecution is going to improve society?).

    ** Let’s assume that you keep the traditional 80/20 domestic/foreign allocation.

    Yeah, you missed out on becoming rich compared to the rest of your peers (the country), but it’s not nearly as big of a deal as your employer going under. Your buying power has remained the same relative to your peers. Now, would you leave the U.S. to seek better economic opportunities? Leave your extended family? Possibly learn another language if all the English-speaking countries hit the fan? Most Americans want to die Americans. That could change, but things would have to get pretty dire. You’d probably just stick it out here knowing that you have it no worse than anyone else you know.

    * Case 2: The finances of the rest of the world fall apart, but the U.S. stays strong

    ** Let’s assume that you do invest 80-90% in foreign investments (the opposite of the traditional advice).

    In this case, you’re screwed. Relative to all of your peers (the rest of the country), you’re broke. Well, in this debt- and consumer-oriented country most everyone is broke, so that just aligns you with your peers. However, in your own mind, you know that you went from believing that you had very carefully managed your finances, to having much, much less. At least there’s a strong government to provide your Social Security.

    ** Let’s assume that you keep the traditional 80/20 domestic/foreign allocation.

    In this case, your finances haven’t changed much relative to your peers. Life goes on in the U.S.. You’re really glad that you don’t live abroad.

    So, the risk is really that you could be left with nothing relative to your peers. That only happens if you buck the traditional allocation advice. I’m a Libertarian, I have nothing against bucking the status quo, but in this case, I would recommend against it. The vast majority of people retire in their own countries, which means that they need their investments to maintain value in their own countries. What happens in other countries may present a lot of opportunity — or it may present a lot of risk — but you’re not retiring in those countries so you want to make what happens in them is secondary as far as your investments go.

  • Dan D says:

    GE,

    Sorry for such a delayed response to the article, but I just started reading your site – I really like it so far!

    I like your analysis and agree with most of your points, but there is one thing I think you may have overlooked: many large companies in the US earn a substantial portion of their revenues in other countries.

    One example, off the top of my head, would be Hewlett-Packard. I believe over 60% of HP’s revenue comes from outside the US. If only 40% of HP/other large-caps business comes from domestic sales, the actual allocation of your portfolio would be 32% US (.8*.4). This does not account for small-cap companies that don’t do much business outside the US, but with the trend toward an integrated global economy I would assume the percentage of revenue generated outside the states to continue to climb.

    I’m not saying that the 80/20 rule isn’t antiquated – I’m merely suggesting it may not be as out of balance as many think.

    -Dan

  • George P says:

    The analysis seems misguided for several reasons.

    First, transaction costs are higher (generally) for international funds. This is because of the higher cost of doing business overseas and making funds available in the U.S. The difference is slight, but compounded over 25+ years, these costs can have a significant, negative impact on a portfolio.

    Second, the analysis fails to consider that most S&P 500 companies have significant profit centers overseas, and many of these companies have parallel listings overseas. Thus, 80% U.S. holdings is more internationally diversified than the raw percentage suggests. Second, the 20% international holdings has more U.S. holdings than the analysis suggests.

    Third, investing in U.S. stocks for U.S. investors making U.S. dollars has virtually 0 currency risk; whereas investing in foreign funds entails significant currency risks. Currently, economic policymakers in the U.S. seem to be attempting to inflate and weaken the U.S. dollar to boost exports; and China pegs their currency to the dollar to mitigate this. While that suggests foreign investments will fare better in the short run, if policy changes, then fortunes will reverse. Further, unforeseen international problems (see Russian crisis in late 1990s) can asymmetrically impact international holdings.

    For a comprehensive rejection of weighting portfolios toward international holdings, see Jack Bogle’s On Mutual Funds. While I disagree with Mr. Bogle’s proposition of 0 international holdings, 20% seems like a solid, reasonable number to me.

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