Is enough of your money invested in overseas stocks?

One of the most important lessons you can learn about investing is just how short people's memories are.

A trend doesn't have to last for all that long before investors start to believe that "it's always been this way".

Take the US stockmarket. It's been trouncing rival stockmarkets for years now. It's expensive everybody knows that. But it deserves to be.

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Doesn't it?

There's nothing special about the US, believe it or not

I read an interesting piece from Mebane Faber of Cambria Asset Management this morning. (I recommend you follow him or sign up for his emails he's very smart and always has a fresh take on things). He addresses this issue of the US market being so much more expensive than the rest of the world's markets.

Faber uses the Cape ratio. This is the cyclically-adjusted price/earnings ratio, which looks at how much investors are paying per $1 of average earnings over a ten-year period.

The point of adjusting over a decade is to iron out fluctuations in earnings over the highs and lows of the typical cycle. Any given year could be a good or bad year. Taking the average gives a better idea of the valuation relative to history.

Now, some people have "issues" with the Cape, but no one seriously argues that the US is not expensive. You can use any measure you want and they'll all agree that while the US might not be the most expensive it's ever been (that was at the peak of the tech bubble), it's certainly up there with the more expensive periods in its past.

One excuse that people have taken to using is that the US is, in effect, the leading economy and the leading market. So it deserves to trade at a premium to the rest of the world's markets to reflect the fact that, ultimately, it's the best.

So Faber took a look at this argument. He runs the figures on the US market since 1980, and compares it to the rest of the world (ie, excluding the US) over the same period. His findings? "Both have an average Cape ratio of about 22." In other words, "the historical valuation premium has been ZERO".

Indeed, non-US stocks traded at a huge premium to US ones for most of the 1980s (this was significantly influenced by the Japan bubble), and at a decent premium for most of the 1990s.

The US was a good bit more expensive than the rest of the world during the tech bubble, but not extraordinarily so. And in the post-2000 run-up to the financial crisis, US stocks were in fact cheaper than those in the rest of the world.

It's only really since the 2008 crash and 2009 recovery that the US has taken off against the rest of the world. I think you can make some valid arguments as to why that might be the case.

The US and the dollar were both seen as safe havens at an uncertain, frightening time. The US took more decisive action to fix its banking system than either the UK or the eurozone. The US has a larger concentration of powerful tech stocks at a time when tech has been the place to be.

But none of these is a structural argument. There is no argument there to say that the US should have permanently moved to a higher plane than the rest of the world's stockmarkets.

Diversification and home bias

What can you take away from this as an investor? The obvious point is that the US is expensive. That might continue for a long time; it might not. But if you believe (as I do) that the sensible way to invest for the long run is to buy stuff that's cheap then sit on it until it's not, then you'll want to look elsewhere.

The other point that Faber who writes mainly for a US audience makes is that investors need to be wary of home bias. According to his data, the average American investor holds something like 80% of their equity allocation in the US. That's not as bad as it sounds, given that US equities still account for about half of global market valuation.

Of course, it's not just US investors who suffer from home bias. It affects investors everywhere.

Interestingly, though, UK investors are a relatively cosmopolitan bunch we hold about a quarter of our money in UK equities. That's still about four times the weighting of UK stocks in global markets, but it's a lot more adventurous than Aussies, for example, who hold about two-thirds of their money in Australian equities, even although the Australian market accounts for a tiny proportion of global equity valuations.

Right now, if I'm absolutely honest, I'd be happy to be "overweight" (to use the jargon) UK equities, simply because I think sentiment towards them is too grim and as a result, they are on the cheaper rather than the more expensive side.

That said, it never makes sense to have all your money in one basket in investment, regardless of how cheap that basket is it can, after all, always get cheaper. And if we have another spasm of panic over Brexit, then it's fair to say that the pound could weaken again from here in which case it's nice to have some of your portfolio denominated in a currency other than sterling.

The good news is that there are plenty of attractive overseas markets out there at reasonable valuations. We like Japan, as regular readers will be very aware. Emerging markets also continue to look appealing. If China is scared enough to start loosening the reins on monetary policy which appears to be the case then emerging markets, and emerging Asia in particular, should be a prime beneficiary (particularly if you'd rather not invest directly in China).

If this isn't something you've considered before now, do take a look at your portfolio. There's no set limit or guidelines but if more than half of your wealth is allocated to your home country (and your home country is not the US) then I'd suggest that you should give some serious thought to diversifying more widely.