Rules of the Game: Look Beyond the U.S.

 | Aug 12, 2013 | 12:00 PM EDT  | Comments
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Stock quotes in this article:

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The retail part of earnings season starts this week. S&P 500 component Macy's (M) reports Wednesday, while Wal-Mart (WMT), Nordstrom (JWN) and Kohl's (KSS) release results on Thursday.

The retail sector has advanced more than 30% year-to-date, outpacing the S&P's 19% gain.

That's all well and good, but it's ultimately unimportant. There are a couple reasons why I'm not overly impressed or excited about particular sector news, when it comes to investing.

First, a sector bet has a limited shelf life. If you are looking to one area within U.S. large cap that will outshine others, and lead you to eye-popping returns, the effect will only be temporary. I can say that with confidence, because there's plenty of historical data to prove that.

Second, a relentless obsession with large-cap U.S. -- that would be the S&P 500 -- is detrimental to your overall investment strategy. How many times have you heard your friends and neighbors bemoan the "lost decade" in their investments?

In the so-called "lost decade," between 2000 and 2009, U.S. large cap stocks declined 2.4%. I understand the tunnel vision when it comes to thinking of this asset class as "the market." There's plenty of reinforcement, throughout the financial media, to limit your view.

But let's take a step back and understand some of the reasoning for that, as it relates to U.S. investors. U.S. stocks constitute 46% of world market cap. That number has declined, as markets in other countries have ascended. But the values of other countries' markets are less than you may think.

Here's a fun little quiz: What percentage of world market cap do you think China represents? I'll just sing the "Jeopardy" theme song while you formulate your guess.

Ready? You think it's 25%? A more conservative 15%? Maybe just 10%?

All of those would be wrong. China's market cap represents just 2% of worldwide value. You wouldn't know that, based on the hype about Chinese companies.

Back to the U.S. market cap. That 46% is far and away the highest in the world, with the United Kingdom and Japan, each with 7% of world market cap, tied for a distant second.

But for those of us who live in the U.S., we have what's called a "home bias." This is the tendency for investors to put a disproportionate amount of their money into domestic issues, overlooking or not understanding the advantages of diversifying into foreign instruments.

In the past, it was more difficult to diversify overseas. These days, the old excuses no longer exist.

I know there's no end to the social reinforcement for trading in and out of asset classes based on speculation. Here's a meme that's very of-the-moment: Interest rates are going up! Sell all your bonds! Now! But that ignores the longer-term effects bonds have, of dampening volatility of equities. It also ignores that bonds of varying durations and credit risks perform differently.

Or, how about the emerging-market panic of 2013? Right now, the MSCI Emerging Markets Index (EEM) may resemble a trading vehicle, rather than an investment. But, for investors with the right risk tolerance, emerging markets can offer expected returns greater than that of U.S. large caps.

So back to the S&P reporting schedule: Yes, it's fun to track how the companies are doing. There are fascinating sociological and demographic observations to be gathered from company reports. There are even times when it's easy to scoff at poor management or at exceptionally skilled management. I enjoy publications like "The Economist," "Fast Money" and "Fortune," which give me insight into global economies and business trends.

 But that's a very different study than making a sector bet on an individual area of the S&P, or even into U.S. large caps themselves.

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