Concern

The size of the markets can work against foreign investors in two ways. First, some securities and some countries may be illiquid. In such markets, any reasonably sized trades are sufficient to move the price. The price rises when one wants to buy and falls upon a sale. This is particularly painful because most foreign investors end up selling and buying around the same time.

The second concern with market size is inefficiency. Emerging markets are known to be inefficient, and prices can take several days to fully reflect new information. As a passive investor, you can lose money to more sophisticated investors who trade on the basis of the inefficiency.

Rejoinder

Liquidity risk exists in all markets, including the U.S. market, where small stocks are very illiquid. The challenge is for the investor to select markets and stocks that are likely to experience a smaller liquidity shock than other countries and stocks. So it would be smart for investors to trade only large, liquid stocks in large, liquid markets.

Market inefficiency can work both ways. It certainly worsens the returns for unsophisticated investors, but smart investors can take advantage of the inefficiencies, thereby forcing the market to become more efficient. In any case, passive investors can choose markets that are relatively less inefficient.

Riskiness of Foreign Markets

Concern

Foreign markets are very risky, much riskier than the U.S. markets. Risk-averse investors are unwilling to accept a higher level of risk.

Rejoinder

Foreign markets, especially emerging markets, are indeed riskier than U.S. markets. However, due to the low correlation between foreign markets and U.S. markets, a portfolio that includes stocks from both markets need not be as risky. The diversification of risk has been illustrated in Tables 10.3 and 10.4. As a matter of fact, holding U.S. stocks only is riskier than holding a world portfolio weighted by the market capitalization of each country.

Persistence

The home bias is nothing new and has persisted for decades. Though the investment in foreign equities has increased from 1 percent to 7 percent over the last two decades, it falls short of the level of optimal foreign investment.

Unlike the mispricings discussed in earlier chapters, it is not possible for arbitrageurs or anyone else to form short-term trading strategies. Over the long term, however, investors who hold foreign stocks will outperform portfolios that are restricted to domestic stocks only.

The only reason that can explain the persistence of the home bias is the ignorance of a typical investor. A comparison of investment in foreign stocks by individual and institutional investors is revealing. According to Fidelity and Pensions and Investments, only 3 percent of the assets held by individual investors are invested in foreign equity, compared with 13 percent for professionally managed pension funds. The two hundred largest corporate pension plans had an allocation of 16 percent to foreign stocks. On the other hand, mutual funds have only 3.5 percent invested in international stocks. The foreign allocation of mutual funds mirrors the individual investor allocation-because individual investors can pick and choose mutual funds and exclude international mutual funds if they don’t want to invest internationally. The pension funds can determine the allocation on the basis of portfolio theory.

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