How to Avoid Becoming an 'American Andrei'

A question you've never considered before... Learning from my friend Andrei's mistake... This common 'bias' could get you in trouble... Stock markets are mutts – not purebreds... Taking 'true diversification' a step further... How to avoid becoming an 'American Andrei'...

What happens if the egg truck crashes – and the road it's traveling on collapses at the same time?

That's a pretty obscure question, I (Kim Iskyan) know.

And no matter how old you are... where you live... or what your financial situation is... I can almost guarantee that you've never thought about it before.

But in today's Digest, I will explain how this seemingly off-the-wall question relates to one of the biggest mistakes that investors all over the world make all the time. And as you'll see, this concept involves more than just investing, too...

It's about taking a much more holistic view of your assets – financial and otherwise.

To put it simply, it's what my Russian friend and former colleague Andrei didn't do...

You see, in the mid-1990s, Andrei was earning good money...

He worked as a junior analyst at the same investment bank that I did in Moscow. He had smartly ridden a rally in the Russian stock market... and he had also invested in bonds.

Andrei also had some cash stored away in a local bank... He put part of his paycheck into the account every month. And he was doing well... He had used some of his savings to buy a small apartment in the outskirts of Moscow, which he rented out to earn some income.

By almost any financial adviser's definition, Andrei was well-diversified...

He had put his eggs into several different baskets – stocks, bonds, real estate, and cash. By spreading his money out into different types of investments, he reduced his risk level.

That's the thing... Andrei made all the right moves with his investments – except one. While he diversified like a champ across different asset classes, he did everything within Russia.

And then, unfortunately for Andrei, disaster struck in Russia...

This time, it was 1998... when deep fiscal imbalances within the country – the government couldn't pay its debt – triggered a currency collapse and economic crisis.

But it could just as easily have been 2008, 2020, or a handful of other times in recent decades when Russia fell into crisis, whether due to collapsing commodities prices, a wobbly banking sector, the aftershocks of crisis elsewhere... or a toxic blend of all of these factors.

The Russian stock market collapsed 93% within months in 1998, and the bond market was obliterated. The banking sector wobbled like Jell-O in an earthquake, and Russian real estate prices fell 30% to 50%.

Andrei had previously taken some profits off the table in his shares of Russian companies... but it didn't help much. With everything in the country spiraling downward, his portfolio was ravaged in a short span.

All these years later, I still vividly remember Andrei's expression above the cubicle divider between our desks when he heard that Russia's largest bank – the supposedly ultra-safe state-operated bank – was freezing withdrawals of dollars... It was a cocktail of despair, horror, disbelief, and anger.

The decision doomed his ruble savings – and those of millions of other Russians – to a devastating devaluation... The currency lost around 70% of its value relative to the U.S. dollar within a month.

In other words, the truck carrying Andrei's financial eggs in different Russian-made baskets skidded out and smashed into a highway divider... just as the road dropped out beneath it.

Now, before we go any further, I know what you might be thinking...

That's what Andrei gets for investing in emerging markets! Those places have a financial crisis as often as I get a haircut. They're way too risky. We don't have those kinds of crises here in America. Andrei played with fire, and he got burned.

It's true... Emerging markets like Russia are riskier than developed markets like the U.S.

They're rife with lousy corporate governance, thieving management teams, foreign exchange risk, and political risk... not to mention the difficulty with buying shares. The list of reasons for why investors should limit their exposure to emerging markets is long.

But the thing is, Andrei wasn't trying to play with fire at all. He was just doing what investors all over the world do – and something I imagine most of you do, too...

You see, Andrei was simply putting the bulk of his assets in his home market.

It was the market most familiar to him, and therefore, where he felt comfortable investing most of his money. It just so happened that his home market blew up in his face.

'Invest in what you know' is an old insight of legendary fund manager Peter Lynch...

The saying suggests that folks favor stocks in their domestic markets. And studies have shown that domestic investors tend to be more optimistic about their local economies than foreign investors.

Plus, investors face fewer tax hassles and less foreign currency risk when buying domestic shares. They tend to trust companies and stocks inside their borders more than they do those outside their own country... even if the "foreign" market is bigger and less volatile than the local market, as was the case with Andrei and his choice of Russia over the U.S.

This is known as "home-country bias." And it's more common than you might realize...

For example, the average American invests a little more than three-quarters of his portfolio in stocks listed on U.S. exchanges. However, the market capitalization of American exchanges only account for around half of the total global market cap – that is, the value of all listed shares on all exchanges in the world.

And that might sound reasonable at first... But as I'll get to in a moment, it's a little bit misleading. The average American investor's exposure to the U.S. is actually a lot higher when you factor in other assets. And on top of that, being "overweight" one market limits the scope to take advantage of the strong performance in other markets around the world.

Home-country bias isn't just an American affliction, either...

The average Australian has around two-thirds of his stock market portfolio in shares listed in Australia, though Australian markets account for just 2% of the world's traded shares. And in Japan, where the stock market is worth about 7% of total global market cap, the average investor has around 55% of his portfolio invested in locally-listed stocks.

Take a moment to think about your own portfolio now...

If you're an American, how much exposure do you have to U.S.-listed securities? And how many times have you bought a stock that is only listed in another country – like Canada, for example? What about any stocks in European exchanges or Hong Kong's Hang Seng Index?

Most people – as I've seen over my lifetime of investing, writing about, and living in international markets – do express some interest in what's going on "over there." But even though you can now invest internationally with just a few clicks of a mouse, they typically act in line with an old Russian proverb... "It's nice to visit others, but home is best."

For example, over the years, a lot of readers have told me that they love hearing about my travels to Uzbekistan, Zimbabwe, Argentina, and Vietnam... as well as the investment opportunities I find in those off-the-radar markets (and in other, less adventuresome markets – like London, Hong Kong, and Singapore). But when I ask how many of these sorts of recommendations they've acted on, they generally just laugh and look down.

And keep in mind that the above data on home-country bias doesn't include real estate...

A lot of folks buy real estate locally, either as their primary residence or for other investing purposes. And not many people buy real estate abroad... So as I alluded to earlier, these figures probably underestimate the actual concentration of investors' assets in their local markets, in the U.S. and elsewhere.

Comparing portfolio exposure to a market's share of the global stock market might also underestimate home-country bias. You could look at the share of a market's economy in total global economic output...

The U.S. economy is now around 24% of total world GDP. (This percentage is calculated by using nominal GDP and current dollars.)

Those numbers would suggest that most investors are even bigger "homebodies."

But investors must realize that stock markets are mutts – not purebreds...

For example, companies in the benchmark S&P 500 Index generate around 30% of their total revenues from outside the U.S. And it's a similar situation with individual stocks... About 60% of Apple's (AAPL) revenue and more than a quarter of Amazon's (AMZN) sales come from outside the country.

"Local" stocks – at least on U.S. markets – often aren't that local at all.

Similarly, many Australian companies are resource-focused... So they're more geared to global commodities prices, rather than what's going on in the Australian economy. In that respect, Australian investors may be a bit less inwardly focused than it first appears.

That tidbit suggests that home-country bias – from a financial perspective – is maybe a little bit less of an issue for American investors than for folks in other countries. But still, the overall point is that nearly everyone in the U.S. is heavily overweight American assets.

And although home-country bias can be defined and analyzed in different ways, one thing is clear...

Wherever they are, investors are wary of putting their money into foreign markets.

As a result, they wind up with far greater exposure in their local markets than diversification guidelines might suggest. They do what's comfortable, instead of branching out in any way.

For my friend Andrei to invest in U.S.-listed stocks... or buy bonds of an American company... or to put 20% down on a little condo in Palm Beach to rent out to snowbirds... it would take a little extra effort. The same can be said for an American investor in Russia.

(This isn't a perfect comparison because American markets are more attractive to – and a magnet of – capital from around the world than most countries... But you see my point.)

If you're not looking abroad, you're missing out on an important part of diversification...

Put simply, a portfolio that isn't sufficiently diversified is riskier than one that is well-diversified... And geographical diversification is an important piece of that puzzle.

During a global stock market correction, most markets tend to move in the same direction. But different markets outperform at different times, of course. So having money invested in a range of geographical markets can boost your returns over the long run...

When one market zigs, another zags.

Heavy geographical diversification doesn't always pay off, though... Over the past decade, American investors have benefited tremendously by being heavily overweight U.S. stocks...

Assuming dividends reinvested, the S&P 500 is up 263% over the past decade, while the iShares MSCI ACWI ex U.S. Fund (ACWX) – an exchange-traded fund that tracks all markets except the U.S. – is up just 59% over that period. And emerging markets – as tracked by the iShares MSCI Emerging Markets Fund (EEM) – have risen just 34%.

But if you believe that outperformance will last forever, remember my friend Andrei... He was doing quite well just investing in his home country – until Russia's markets collapsed.

As my colleagues have been discussing in the Digest in recent weeks, the "Melt Up" in the U.S. stock market is here. You want to take advantage and make money however you can.

But at the same time, you also need to start preparing now for what's next. And making sure you're diversifying your assets beyond U.S. stocks is a key step in that process...

For example, my friend and Extreme Value editor Dan Ferris often talks about 'true diversification'...

As regular Digest readers know, Dan is a fan of diversification... He suggests having plenty of cash (around 20% of investable liquid assets) ready to take advantage of market declines and volatility... along with a mix of stocks and bonds, other assets that you understand well (real estate, collectibles, or whatever else), and stores of value like gold and bitcoin.

By arranging your overall portfolio in this way, Dan believes you'll be prepared for whatever happens in 2021 and over the next several years. As he said in the December 23 Digest...

I call this "true" diversification because if all you own are financial assets, you're not truly diversified... no matter how many different stocks and bonds you own. You're only truly diversified if your portfolio includes assets inside and outside the currency regime [like gold, silver, and bitcoin].

Remember, the purpose of this truly diversified portfolio is not to predict that stocks, bonds, gold, silver, and bitcoin will all go up together forever. It's quite the opposite...

The purpose of true diversification is to own assets that tend to do well at different times.

That makes a lot of sense. And as Dan concluded in that Digest, going forward, you'll likely experience less volatility and anguish than investors who don't follow a similar blueprint.

But I suggest taking it a step further in the bigger picture of diversification...

Assets – and diversification – are about more than money...

So far in today's essay, we've talked about how most folks suffer from home-country bias... about the dangers of being "overweight" your home country... and about adding non-currency assets, and plenty of cash, to the mix to achieve "true diversification."

But I believe our discussion of diversification is missing a critical component...

When it comes down to it, your financial assets are a dollar sign. But just like potential energy is stored energy, a more complete vision of your assets would need to include how you generate the income that ultimately results in the accumulation of your financial assets.

This more holistic definition of assets includes a lot of other inputs...

It includes your professional experience... your education... your qualifications... and your network. It also includes things like the languages you speak... the places you've lived... and the citizenships you hold.

These parts of your life don't translate directly into any dollar figures... But without them, the process of collecting financial assets will be short and not very fruitful.

Back to my friend Andrei, whose 'personal assets' weren't well-diversified, either...

I've already talked about how, in some ways, Andrei was well-diversified... except that he had nearly all of his financial assets in the same country and market.

As it turns out, not surprisingly, Andrei's "personal assets" – which were central to his future earnings power (and financial-asset accumulation) – were concentrated in the same egg truck on the same soon-to-be-collapsed highway, too.

You see, he had grown up in Russia... went to college in the country... worked in Russian finance at a Russian bank... spoke Russian (and passable English)... held a Russian passport... and had a personal and professional network heavily concentrated in Russia.

So when the Russian economy sank like a broken submarine, it took Andrei's financial assets with him – as well as his personal assets... and his ability to generate income (and financial assets) in the future.

Today, I encourage you to make sure you're not an 'American Andrei'...

Many Americans have nearly all of their financial and personal assets in the country.

Think about it...

Do you own anything outside the U.S.? Do you have any assets in a different banking system? Can you speak another language? If the American economy collapses, will you lose everything... or will you be able to keep on ticking? Is all of your money in U.S. dollars?

And yes, the U.S. is a better "home country" to have most of your assets concentrated in than many other markets and countries (like Russia). But while the American economy may be more stable than many others today, that doesn't mean you should go "all in" on it. Plus, you may not realize just how "overweight" you are in your exposure to America.

After all, no one can predict the future. We never know exactly when disaster will strike...

Remember, less than a year ago, the S&P 500 fell an emerging-markets-like 34% in about a month. In April 2020, the unemployment rate in the U.S. increased by more than 10 percentage points, as nearly 16 million people lost their jobs due to the COVID-19 panic.

And whether you agree with him or not, the "America First" policies of Donald Trump's administration destroyed – perhaps beyond repair – the international standing of the U.S. as a reliable partner for many countries... along with its status in global geopolitics.

For now, the U.S. dollar is the world's reserve currency... That allows the federal government a lot of leeway to print currency with limited macroeconomic repercussions. But as I've written before, in the October 9, 2020 Digest, this situation won't last forever... especially as ever-escalating stimulus packages continue to be passed through Congress.

And with global COVID-19 restrictions, the world is a lot smaller...

In January 2020, a U.S. passport could get you visa-free entry into around 184 countries, making it one of the most valuable travel documents in the world. But after many countries imposed travel restrictions on U.S. citizens in the wake of the COVID-19 pandemic, the utility of an American passport collapsed... Now, it can get you into just 50 countries (though with COVID-19 restrictions). Most American citizens can't even go to Europe now.

In other words, right now, an American passport is about as valuable, travel-wise, as a passport from Algeria or Turkmenistan was before the pandemic began. And while a return to "normal" in a world after COVID-19 might rectify that somewhat... again, no one can say for certain what the future holds.

Fortunately, you can take some simple steps to (properly) diversify yourself...

Many investors are perfectly happy with having nearly all of their assets in their home country... especially if it's a big, (mostly) stable market and environment like the U.S.

But as we've often written before in these pages, U.S. dominance won't last forever...

We've already seen how quickly the door can slam on American passport holders. And last spring, we experienced how American markets and the country's economy can collapse with the kind of ferocity that is normally the domain of banana republic economies.

So if you're looking for ways to prepare today, I encourage you to do this...

First, financially, simply shift some of your assets out of U.S. stocks. One easy way to do this is by buying shares of a one-stop-shop, international exchange-traded fund...

You could buy the low-fee Vanguard FTSE All-World ex-U.S. Fund (VEU). Or if you think it's time for emerging markets to return to the mean and start performing better, you could consider investing in the Vanguard FTSE Emerging Markets Fund (VWO). These funds offer easy exposure to the rest of the world through your regular brokerage accounts.

And if you're more adventuresome, it has never been easier to buy shares of foreign companies – whether they're listed on U.S. exchanges or on foreign exchanges... Many online brokers have made it almost as easy to buy shares in London, Hong Kong, and other global exchanges as it is to buy shares of Microsoft (MSFT) or Alphabet (GOOGL).

Sometimes you might need to fill out an extra form or two, but it generally doesn't take too much additional effort. You'll also need to consider taxes. Tax situations are personal, and we can't know everyone's... But your broker or tax professional can answer any questions.

Finally, if you haven't already, I encourage you to watch our "2021 preview" event...

Our Director of Research Austin Root joined my colleagues Dr. Steve Sjuggerud and Dr. David "Doc" Eifrig this week to set the tone for the year ahead. They talked about the investing trends that they're excited about... the ones they're nervous about... and more.

And best of all, they laid out a complete playbook for how you can come out on top of the wildest stock market in 10 years. Their message focuses on the financial side of our diversification discussion... And it's a must-watch for anyone with money in the markets.

Plus, they each shared a free recommendation with everyone who tuned in. And Steve's recommendation is a Chinese company, so that's a great start for your diversification plan.

If you missed the original broadcast earlier this week, you're in luck... For a limited time, you can watch the full replay right here.

Diversifying your portfolio investments outside the U.S. is a good start...

But there's a lot more you can – and should – do in order to fully diversify your assets...

Consider putting some money into a different banking system – and currency.

Explore opportunities to get a second citizenship... You never know when it will be time to "get out of Dodge." And as we've seen over the past year, you also never know when your passport – your ticket to leave Dodge – won't get you to as many places as before.

Owning real estate abroad is a great option to help you diversify your assets as well. (If you're interested in learning more on how to do that, I wrote an article in online magazine American Consequences back in May 2020. You can read it right here.)

Maybe you're not at the stage of life where you can pick up and work in another country... live in a faraway place just because you want to... get a degree at a foreign university... or learn Spanish by living in a Spanish-speaking country.

But living abroad, for whatever reason, is the best way to diversify your personal assets...

In time, it can become a part of who you are and how you live. And if it's not for you specifically, it may be something that your kids – or their kids – can explore and discover... as part of building up and diversifying their personal assets.

And in case you're wondering, Andrei's story thankfully has a happy ending...

Andrei was bloodied by the 2008 financial crisis in Russia... but he wasn't broken.

He realized that he was overweight Russia – in terms of both his financial and personal assets – and worked hard to fix that in the ensuing years...

First, Andrei went to England for business school. He worked there for a few years... dramatically improving his language skills, earnings power, network, and professional opportunities outside of Russia.

Later, Andrei further diversified by launching a specialty retail website... writing books about fitness, one of his favorite hobbies... and funding a neighborhood toy store. And he did all of that while moving on from banking to become the head of finance at a furniture company.

When we last spoke last summer, Andrei remained optimistic even though the Russian economy was suffering yet another body blow – this time from COVID-19. He planned to send his teenage kids to school in England to give them exposure to the rest of the world... to help them boost their personal assets at a young age.

So with that, I leave you with a few simple questions to consider this weekend...

What are you going to do? Will you remain an American Andrei? Or will you make a plan just in case the truck carrying all your eggs crashes while driving on a crumbling highway?

The choice is yours...

New 52-week highs (as of 1/28/21): First Majestic Silver (AG), Cango (CANG), Commvault Systems (CVLT), Harrow Health (HROW), Microsoft (MSFT), Nuveen Municipal Value Fund (NUV), and OptimizeRx (OPRX).

In today's mailbag, more feedback on Dan's Digest from last Friday. On a related note... Dan is off today, but he'll be back next week. What's on your mind? Send your notes to feedback@stansberryresearch.com.

"Dan, thank you! I love your theme of 'preparing, not predicting.' You always make me think.

"As I was reading your essay, I was reminded of the trite expression: 'expect the unexpected.' Putting the mental gymnastics that requires aside, it's not so much about expecting the unexpected as it is in being prepared for the unexpected. Though perhaps somewhat nuanced, there is a huge difference (and potentially, a huge difference in the outcome) between the two. Thank you for drawing such an important distinction between the two.

"Most people are superficial thinkers... you are not, and your readers are the better for it. Lead on, my friend." – Paid-up subscriber Dale W.

Good investing,

Kim Iskyan
Dublin, Ireland
January 29, 2021