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Risky Business
From: Columbia University
| By:
Geert Bekaert |
EDITOR'S INTRODUCTION |
 Though investors around the world exhibit "home bias," the desire to hold a majority of their stock portfolio in their native country's market, international diversification is a safer way to invest, according to Geert Bekaert, professor of finance at Columbia Business School. In this interview, Bekaert assesses the risk involved in investing in foreign markets and the security that is gained by having money in different countries whose markets operate independently. |
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| Geert Bekaert talks about models and formulas for investing. | |
Fathom: From an investor's point of view, what's the biggest thing that can go wrong in international investing? Should one be fearful in any way, and, if so, fearful of what? |
Geert Bekaert: There are a couple of risks that you don't have at home. The first risk is currency risk. That's a risk that applies to any market. It applies to the UK market, it applies to the European markets--although it's a little bit different now, as there's only one currency to worry about anymore, which is the euro for most of these markets. And it applies with more force to the emerging markets. |
Currency risk would appear to be an extraordinarily important determinant of your investment return. A lot of mutual funds that invest in international markets will warn investors and say there are a lot of risks to consider, which are not present in other investments and which you do have in investing internationally. |
Currency risk should not be exaggerated. It is true that if you look at the UK market with and without currency risk the local returns are less volatile than the dollar returns on the UK equity market. There's a little bit more risk that the currency adds. But it's less than you think. Currency gains and losses themselves are not very highly correlated with the equity markets, so there's some diversification there. Also, I'm really in favor of having an internationally diversified portfolio. That means that you're going to have different countries out there with different currencies. That again will lead to diversification potential. Basically, some of that currency risk will be diversified away in your portfolio. |
Also, if you're still worried, you can get rid of it. You can actually hedge your currency risk. There are contracts out there--forward contracts, options--that would allow you to hedge the currency risk. But I would actually advise any investor that has a well-diversified portfolio to not even worry about that, not to do that, because the hedge itself is going to cost time and money, and it's really not worth your trouble. The currency risk is really not going to be a very big factor in determining your return on equity markets. |
Fathom: What's the risk involved in investing in foreign markets? |
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| Geert Bekaert explains what constitutes a risky market. | |
Bekaert: Your concern in emerging markets, which is not so much a concern in the developed markets, is political risk. And I would think about that in a very broad sense. Political risk means that there could be a coup and suddenly some dictator may grab power and close the stock market. A lot of these markets are open right now, but what happens if a crisis hits like the ones in Mexico in '94 and Southeast Asia in '97? What will happen if a crisis hits? First of all, the crisis itself is really bad for you, but then they may also close down the market. They may keep your money there. They may confiscate it. I would almost call it integration risk. Markets have been liberalizing, they have been going toward integrating with the world capital market, but that process could be halted and reversed. |
After the Southeast Asia crisis, what we have seen is that in Malaysia the prime minister suddenly said, "The foreigners are to blame, and now I'm going to reimpose capital controls, I'm going to stop this process of integration and I'm going to keep the foreign money here and maybe I'll give it back to you." Now, that's obviously a disaster scenario, and that's a risk that's somewhat difficult to hedge. You just hope that, because of that risk, maybe the prices would have been lower, and that, by taking that risk, you're going to get a higher expected return, which is what we believe in finance. And there's actually some evidence for that. There's some evidence that political risk is priced, these countries that are subject to that risk have lower prices. In fact, the action in Malaysia will mean that now people are going to be very wary of Malaysian stocks, because they know there's this character out there that can randomly decide to suddenly close the market again and leave you hanging. So that's a risk that will be priced in and that will lower the prices of Malaysian stocks. |
Fathom: Is there something about a country that one should research? Is there some key that might tell you what the political risk factor might be? |
Bekaert: Yes, there's actually quite a bit of research on this, but it's obviously very difficult to predict. Some of the political risk could be more broadly construed as an economic risk; there could be a big currency crisis happening and there could be just bad shocks to this country. For example, think about a country that just exports one commodity. Think about Zimbabwe exporting copper. Well, you know that if the copper price tanks that could have very dire consequences that could also have political consequences, because that will put the country into a recession, which will lead to unemployment, so maybe now some dictator will step in. So it's all correlated. Economic risk and political risk are correlated. The question is: Can you predict that? A lot of people are trying. |
They are trying to look at macroeconomic indicators, they're trying to look at indications, political unrest in countries, and they try to predict whether there is a lot of political risk or not so much risk in particular countries. In fact, there are a lot of institutions that provide formal measures of political risk. There's the Economist Intelligence Unit, and Institutional Investor has a survey. A lot of what these services try to do is rank countries according to political risk. "Institutional Investor," for example, has a ranking between zero and 100. If you're close to 100, you have no political risk; if you're close to zero, you have tons of political risk. |
There have been some financial researchers, including me, who have tried to look at these measures and have tried to see whether they're priced, whether it's true that countries with a lot of political risk have on average lower stock prices and give you higher expected returns. If you buy these stocks, you are going to take more risk, but maybe if you diversify a little bit and you're holding on long enough you kind of get rewarded for taking the risk, and you get higher expected returns. There seems to be some evidence that that's the case. So it's priced. You cannot completely diversify it away, but the good news is that you get high expected returns for being willing to bear that risk. |
Fathom: So should you diversify along the political risk scale? |
Bekaert: If you think about investing in emerging markets, you don't want to do it by concentrating in one country. I would say that you want to be regionally diversified; you want to be country-diversified. There is also some evidence, but it's not very strong, actually, for regional contagion. The Southeast Asian crisis happened in all of Southeast Asia. If you had an emerging market portfolio concentrated in that region, bad luck, because the whole region went down. And there are a lot of economic reasons that there may be regional contagion. Suppose it goes really bad in Thailand. Who does Thailand trade with? Well, they trade primarily with their neighbors, Malaysia and other countries. So bad shocks get transmitted from one country to another, sometimes rationally, as in the example of trade, and also, a lot of economists believe now, sometimes irrationally. Thailand goes down, and so investors have this herding feeling and they say, "Thailand goes down, the other markets are going to go down, too," and they withdraw their money, and that leads to a fall. But you can think about economic reasons, and trade is a very good one. If it goes bad in Thailand, it is going to go bad in a lot of their trading partners. They are not going to import anymore from other countries, so these countries are going to now get negative shocks to their stock markets and they will go down as well. |
If you know that this could happen, you are very wise to regionally diversify away from that region and also invest in Latin America and maybe some African countries, maybe some emerging European countries like Portugal and Turkey, and move away from this regional concentration. |
Fathom: What constitutes a risky market? |
Bekaert: The UK market by itself is riskier than the US stock market. There's no question about it. There's actually risk here for two reasons. One is that the US stock market has the lowest risk, the lowest variability of all the stock markets in the world. One of the reasons is that it's actually a very well diversified market. It has thousands of companies; every single industry is represented in the US stock market. And that makes the stock market one with very low volatility. |
What I mean by volatility is the dispersion of returns. If you look at a particular year, the average return you are getting in the US stock market is about, over the long run, 13, 14 percent, maybe a little lower, maybe 11, 12 percent, depending what period you're looking at, and the volatility, the dispersion around that, is about 15 percent. What that means is that about 95 percent of the observations are within two volatilities above or below the mean. You can have returns over 30 percent and that's reasonable, and you can have returns of minus 10 percent. |
So this volatility, this dispersion, is a measure of risk. It's a measure of how variable my returns are from one year to the other, how much can they move up or down. For the US market, look at that and you can summarize it as 15 percent. For one UK stock market it will be higher. It's actually 23, 24 percent. It's much higher than that. And every single stock market in the world is more variable than the US stock market. |
Why is there more variability in UK equity returns? Because the UK equity market is not as well diversified. And a second reason, of course, is that, for the US investor, if he looks at the UK stock market he is not only caring about the UK equity market; he also cares about the dollar return on the UK equity market. So he's got two risks: currency risk and the equity market risk. And those two combine to make the UK equity market actually more volatile than the US stock market. |
Fathom: As a US investor, why would you then invest in the UK equity market? |
Bekaert: The reason, basically, is that you shouldn't just look at the UK market by itself. You have to think about what happens when you add that UK market to your US portfolio. And that's where diversification comes in. Because if you look at a portfolio of US equities and UK equities together, the variability of that actually depends on both how variable those two markets are and on how well they diversify risk together, the correlation between the two. The correlation between the UK and the US markets is not perfect. Sometimes when the UK market goes up, the US market doesn't do as well, and so forth. That means that the total variability of that portfolio may well be less than the variability of the US portfolio. That's the magic of diversification. |
It so happens that the UK market is actually one of the markets in the world that correlates with the US market. The correlation is about 0.5. The correlation is a number between minus one and one. If there were perfect correlation, then you couldn't really diversify risk. In any stock market in the world, there are no perfect correlations to be observed, so you can always diversify risk. But of course the higher they are the less the diversification potential. So the UK market from a diversification potential is not the best market out there, because it has a relatively high correlation with the US stock market. |
Fathom: What value is gained from investing in emerging markets? |
Bekaert: Emerging markets, for example, are much better, because they have very low correlations with the US markets, sometimes as close as zero, 0.1--very, very small correlations. That means if you add just a little bit of these emerging markets to your portfolio you may actually reduce the variance, the volatility of your portfolio, which is very surprising to a lot of retail investors. They see these emerging markets out there--like Argentina or Korea--and they look at these markets by themselves and they appear extremely risky. And they're right. If you had a portfolio 100 percent invested in the Argentinean stock market, you'd be crazy, because there's a lot of variability there, there's a lot of risk. But the key thing is to just take a little bit of it in your portfolio. If you just take 5 or 10 percent of your total portfolio in emerging markets, or maybe even less if it's just one market, then that will be a very good diversification tool. Why? Because the emerging market investment has such low correlation with the US stock market, the total variability of your portfolio, consisting of the US plus the emerging market, may even be lower than the 15 percent you started with. A lot of times it actually will be lower. And that's the great thing about international diversification that a lot of people actually don't quite understand. |
If you have a US portfolio and you're thinking about diversifying your risk, it's much better to buy a little bit of Mexico or Argentina or South Korea than to buy your next growth stock that is sitting in Silicon Valley and doing some Internet business, because that stock will be very variable. It will be as risky taken by itself as the emerging stock market, but it will also have a very high correlation with the US stock market, meaning that if the US stock market tanks by 10 percent your little stock in Silicon Valley is likely to go down by 30 percent. And that might not happen in the Argentinean stock market; it may actually go up by 20 percent. So it's much better to do Argentina rather than the high-growth, small-cap stock in Silicon Valley. |
Fathom: Is there a formula for how much emerging market stock and how much Western Europe stock one should have in order to diversify an American portfolio? |
Bekaert: If we think about formulas to predict what you should be holding as an optimal allocation into emerging markets versus Europe versus the US, there are actually some formulas out there, and there's a lot of dispute about what the right formula is. But one of the most popular models in the academic community is the so-called capital asset pricing model. It was developed by Bill Sharpe, Jan Mossim, a Norwegian academic, and Ann Lintner back in the '60s, and in fact Lintner died too young, but Bill Sharpe did get the Nobel Prize for developing this model. It's a very important model that we use in all of our finance classes for M.B.A.s in all the top business schools.
What the model predicts is very strong. The prediction it makes is that everybody should be holding the market portfolio in equilibrium. Basically, you should be mixing a risk-free asset, something like a T-bill with the market portfolio. |
What is the market portfolio? Well, it's the portfolio that takes all the securities that are being traded in the world out there and mixes them relative to their market capitalization. So if you're sitting in the US your portfolio should consist of about 47, 50 percent US stocks. Why? Because US stocks are a very big proportion of the world market portfolio. But the rest of your portfolio should be diversified all across the world. That's sort of the main prediction that this model has. It's an extraordinarily strong prediction and it basically uses the idea of equilibrium. |
If supply of securities has to equal demand, the prices have to be such that everybody is happy holding the stocks that are available right now, and if you take this idea a step further it really means that everybody should be holding the same portfolio. Obviously that prediction is not borne out in the data. In fact, the phenomenon of "home bias," where people invest more in the stocks of their home market, the market of the country in which they live, is inconsistent with the predictions of the capital asset pricing model. Nevertheless, that's the most simplistic possible model that would give you a prediction for how much to hold in France and the UK and in emerging markets. |
What it would say is that in emerging markets you shouldn't hold very much. What this model would predict is that emerging markets as a whole are about 10 percent of total market capitalization, so about 10 percent of your portfolio should be in emerging markets. |
Fathom: So, if you were in Indonesia and were an investor, how would that model apply to you? |
Bekaert: It would be the same. An Indonesian investor, because the Indonesian market is extraordinarily small relative to the world market, would be much more internationally diversified than the US investor would have to be, because the Indonesian market is just a tiny fraction of the world market. So it would be very much more internationally diversified. |
Now, if you look at that particular prediction, is it true if you look at the smaller markets, the smaller countries. Are they more internationally diversified than the US market? That is borne out. You go to Belgium and it is actually the case that the Belgians are more internationally diversified than the US people are, as they should be, because the Belgian stock market is an extraordinarily small portion of the total stock market in the world. However, again, we still have that home bias phenomenon. They're still not diversified enough. They still have way too many of their assets in Belgian stocks and they shouldn't have that. |
One country that actually stands out a little bit, and it has a long tradition in international investments, is the UK. They're still home biased, but they're quite internationally diversified, compared with other countries. They're much more toward the ideal model, the capital asset pricing model, than are these other countries. And that goes back to the colonial days. Even in the early twentieth century the UK investors were already very internationally diversified. Well, one of their big investments was the US at that time, and they were buying US stocks and Russian bonds, so nothing much has changed, actually, for the UK. |
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