Here’s how a broadly diversified portfolio with international exposure ultimately produces more stable returns.

Australians love to travel abroad. Indeed, even when you head off to some of the lesser-travelled, farthest-flung places on the planet, there’s a good chance you’ll run into another Aussie somewhere along the way

But when it comes to investing, it’s a different story. Many Australians aren’t quite so adventurous – they prefer to stay at home.

There’s a range of data that supports this. For example, the 2020 ASX Australian Investor Study found that while 60% of all Australian investors owned domestic shares directly, only 15% also held international shares.

That trend hasn’t really changed since then. Australian Tax Office data on self-managed super fund investments released in March this year shows 29.1% of total SMSF assets were invested in ASX-listed shares at the end of December 2022, but only 1.8% were invested in overseas shares.

That’s despite the fact that Australian-listed companies by total market capitalisation represent only around 2% by value of the global equities market.

The home bias phenomenon

In the investment world being averse to investing offshore a behavioural phenomenon known as “home bias”, and it’s not unique to Australia.

Pick almost any country in the world and there’s bound to be a high degree of home bias there too.

Share investors naturally gravitate towards home-grown companies for a number of reasons. These companies are often corporate brands they interact with on a daily basis.

Home bias also can reflect fears that offshore investments can be riskier, more costly, are prone to exchange-rate volatility, and have different shareholder rights.

In the Australian context, there’s also a taxation explanation behind home bias. The tax benefits of dividend imputation encourage investing in Australian shares because of expectations of higher returns (from franking credits) relative to other sources of returns.

Yet, analysis by Vanguard shows investors with broadly diversified share exposures to Australian and international markets have generally experienced lower portfolio volatility over time than investors with just Australian share exposures.

To build a robust portfolio you need to think about diversification. Intelligent diversification isn’t just about investing in a bunch of different things but investing in assets that respond differently to the same factors or phenomena. That’s where international shares come in.

Adding international shares

Take China for example. Some conservative investors are averse to the volatility and “emerging market” nature of Chinese equities, assuming they are just too extreme for their taste. But if Chinese equities are zigging when other global equity markets are zagging, adding China to a broadly diversified portfolio in the right quantities could reduce overall portfolio risk. Other low correlation global equity markets could provide valuable diversification benefits too.

Let’s look at some numbers, using the MSCI All Country World ex AU Index in Australia dollars as the benchmark performance measure for international shares and the S&P/ASX 300 Index as the Australian shares benchmark.

On an annualised basis, international equities outperformed Australian equities by 4.5% per year since 2010. This reverses when looking back to 2000, with Australia outperforming by 2.7%. This reverses yet again since 1970, with international outperforming by 0.8%.

In fact, looking at any one-year period since 1970, Australia has outperformed international equities just over 50% of the time, while having higher volatility almost 70% of the time.

Meanwhile, a diversified portfolio allocation of 60% to international shares and 40% to Australian shares often delivered returns that may not have been the best but were never the worst. In fact, since 1970 the diversified portfolio outperformed both international and Australian shares by 0.1% and 0.9% respectively, all while having returns that were 5% to 25% less volatile.

What do these numbers tell us? Firstly, the respective investment returns have differed over time.

But, more importantly, although the returns from different asset classes do change, the reduced risk associated with having a broadly diversified portfolio ultimately produces more stable returns.

The behavioural benefits of diversification can outsize the financial benefits too. During volatile periods investors with under-diversified investment portfolios often feel pressured to make rash decisions when their concentrated strategy produces poor results.

A free lunch

Good investing isn’t about earning the highest returns every year, because the highest returns tend to be one-offs that can’t be repeated. It’s about earning stable returns that you feel you can stick with and which can be repeated for the longest period of time.

The Nobel Prize laureate, economist Harry Markowitz, once reportedly said, “Diversification is the only free lunch” in investing. This assertion has been shown to have stood the test of time.

Investing in assets across geographies and currencies could reduce risk within your portfolio and enhance your returns over the long term. Let’s go get our free lunch Australia.

* An iteration of this article appeared in The Australian Financial Review.

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