Asset Allocation Part 2

I have a confession to make.  I suffer from 'home bias'.  What is 'home bias'?  Read on:

In my last post I discussed asset allocation between 'growth' assets such as shares and 'defensive' assets such as cash.  This post is a tricky one, perhaps with no 'right' answer.  Let's say we've decided on an allocation to growth assets, be it 20% or 80%.  How will we then split that amongst different growth assets? Let's start with Shares from different countries and regions.

Back in the early days of finance theory some would have suggested we hold the global market proportionally.  This would mean holding approximately 2-4% in Australian shares.  Yet we see most balanced funds have somewhere between 50-75% of the growth assets in Australian shares and property.

There are a few reasons I think this is the case, some of them good reasons for this 'home bias'.  I won't go into finance theory but will focus more on the practical reasons:

• Australian residents (and our super funds) are usually eligible for franking credits from dividends.  In our superannuation funds this will often reduce the overall tax paid on earnings of the fund and so increase after-tax returns
• Currency fluctuations can also impact international share returns in Australian dollars.  However in an international fund hedged to the Australian dollar, imperfect currency hedging can be a drag on returns (and lead to increased tracking error: make it more difficult for a manager to track their index)
• Australians may just be more comfortable with local shares, making a 'home bias' more marketable

Having some international exposure is likely to be beneficial over the long term.  The key reason is diversification - when they're not perfectly correlated (don't always move together in the same direction) diversification of volatile assets with similar expected returns can actually lead to higher returns with lower risk.  For more on the conceptual details of this I strongly recommend reading one of the books below by William J. Bernstein.

Unfortunately we can't know ahead of time which combination of assets will perform best over the next year, 5 years, 10 years, or 30 years.  So some criteria I see as important are:

• Having a sufficiently diversified portfolio to smooth possible outcomes
• Having a portfolio containing a balance of assets which still allow you to sleep at night!

The latter criteria may not seem entirely rational.  My key point with it is that making constant changes to your asset allocation (for example purposely lowering your allocation to US shares when they're doing badly relative to Australian shares, say) is paradoxically a good way to lose money (as we're selling low and buying high).  And if you're not comfortable with, say, more than 50% international shares it greatly reduces the chances of 'staying the course' during the inevitable ups and downs.

Personally, I'm now comfortable with somewhere around the range 35-50% of my share allocation in international shares and 50-65% in Australian shares.  This may or may not be optimal but is a plan I can handle and will hopefully give me sufficient diversification over the years.  What are your thoughts on asset allocation - have you been able to overcome 'home bias'?

Links:
Vanguard paper on home bias
I'd greatly appreciate any comments with good guides to asset allocation in Australia. I haven't found an Australian book that comes close to the William Bernstein books below:

The Four Pillars of Investing: Lessons for Building a Winning Portfolio

The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between

I'm currently reading The MoneySense Guide to the Perfect Portfolio.  It's a very short book, costs $4.99USD on Kindle/iPad and provides a nice first introduction to Asset Allocation with index funds.  While the Bernstein books above are written from a US perspective, this one is Canada-focused.  So the specific products are different (e.g. we have Super, not RRSPs) but many of the challenges are similar: Asset Allocation in a country with a relatively small, undiversified local stock market (skewed towards Financial and Commodity stocks)

If you'd like to see how different combinations of assets have performed over the last 40 years, Vanguard have a calculator.  While past performance need not be reflected in future performance it's some comfort to know that over reasonable time periods there hasn't been so much difference between 55%/45% Australian/International shares and 65%/35% Australian/International shares.
Rick Ferri also points out that getting close to the right asset allocation is usually best, rather than worrying down to that last 3%