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Monday, 3 December 2007

Don't Listen to Bogle and Diversify Across Countries

American index fund guru John Bogle warns that you should not own too many funds. He also believes you shouldn't hold international funds, i.e. non-US funds. He said the following:
I am not persuaded that international funds are a necessary component of an investor's portfolio. Foreign funds may reduce a portfolio's volatility, but their economic and currency risks may reduce returns by a still larger amount. The idea that a theoretically optimal portfolio must hold each geographical component as its market weight simply pushes me further than I would dream of being pushed. (I explore the pros and cons of global investing in Chapter 8.) My best judgment is that international holdings should comprise 20 percent of equities at a maximum, and that a zero weight is fully acceptable in most portfolios.
This piece of advice from Bogle I think is a huge mistake. Picking countries, and especially having a bias towards your own country, goes against the point of indexing, which is to capture all returns from the market.

In the same way that you buy an index fund to get broad exposure to the market without having to risk selecting stock, so too investing in many countries gives you broad exposure to the world market without the risk of selecting countries. Why select your own country and not another? Rational investors cannot be patriotic.

Asset class diversification, e.g. investing in shares, property, fixed interest, and cash, can protect you when, say, the share market starts to go wobbly. Your holdings in fixed interest and cash will stabilize your investment. Diversification across countries helps when a shock occurs that is specific to one country. Suppose you live in Iraq just before George Bush declared war against Saddam Hussein. You wouldn't want to keep all your money in Iraq.

Update 4/12/07:
I've found evidence on the Bogleheads forums that Bogle has recanted his old position:
....consider having a large chunk of foreign equity in the portfolio. I'm well-known for ignoring overseas investments--I thought they were too expensive and too full of speculative accounting practices. However, I'm worried about the US economy now--our excessive borrowing for costly wars, an underfinanced pension system and the dollar's weakness. In the next few years, I'm planning to put as much as 20% of my equity holdings into foreign stocks. That includes 10% in developed countries and 10% in emerging markets.
The US economy is not the be all and end all. As I always say, a rational investor cannot be patriotic. Patriotism is irrational. Patriotism should be listed alongside framing, loss aversion, etc as a cognitive flaw in behavioral finance textbooks.

Bogle always warned us to buy and hold and not try to time the market. If we do time the market what happens is when a company is going well we buy and miss out of the gains. If the company does poorly we sell and miss out on the rebound. Bogle seems to have done the same thing with countries. He is country timing! When the US is doing well relative to non-US shares, buy US shares. But when the US is doing poorly relative to non-US shares, sell US shares. Same thing.

Some people love Bogle. I admire Bogle a lot. I am not anti-Bogle. The man is a true financial heavyweight whose advice has saved many investors from the greedy hands of financiers. But I think it's important not to idolize him as a God. When you research financial advice you should diversify across many advisers.

Many of my friends who invests in focused portfolios gave the following quote to me:

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing." ~Warren Buffet

Oh, Warren Buffet! The prophet has spoken! Many people interpret this as an argument against diversification, but I see it as an argument for it. How do you know what you're doing? How does your fund manager know what he's doing? If you truly believe the market is efficient then you can't really know anything that the market already knows. So you diversify because of ignorance and don't pretend that you know something.

What if you really think you do know something the market doesn't know and because of this you can beat the market? Well then become a day trader and forget about indexing.

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