Understanding Index Funds and International Investing
This article explores different investment strategies, particularly focusing on index funds and the debate surrounding international investing. It delves into the rationale behind choosing specific indices and offers a contrarian viewpoint on diversifying globally.
Index Fund Selection
The Dow Jones Industrial Average (DJIA)
The DJIA is considered a less than ideal index due to its limited scope of only 30 stocks. While it may mirror the overall market trends, its variations can be significant. Furthermore, the specific formula used to construct the DJIA and its associated implementation costs make it a less efficient index.
S&P 500
The S&P 500 was initially chosen as the primary index due to its established recognition, especially within the corporate pension market. It was the standard benchmark used by retirement plans. At the time, it was essentially the only well-known index available.
Total Stock Market Index
A total stock market index offers broader coverage compared to the S&P 500. While the S&P 500 historically held a strong correlation with the total market, it primarily represented large-cap stocks. The remaining market capitalization was distributed among mid-cap and small-cap stocks. The Extended Market Index Fund was later created to capture the remaining portion of the market, offering investors a way to achieve complete market exposure. Currently, total stock market indices have surpassed the S&P 500 in size.
The Debate on International Investing
Investing in US Dollars
One perspective argues for focusing investments solely within the United States. The rationale is that income, savings, and expenses are all denominated in US dollars. Therefore, sticking with dollar-denominated investments eliminates concerns about currency fluctuations and related complexities.
International Exposure Through US Corporations
Another point highlights that US corporations already have significant international exposure. It is estimated that roughly 50% of the revenue and earnings of US companies are derived from outside the United States. This suggests that investing in US equities inherently provides some level of international diversification.
Standard Deviation and Market Efficiency
The speaker challenges the usefulness of solely relying on standard deviation and the efficient market theory. It's argued that the average investor might not fully understand standard deviation. The efficient market line, which guides asset allocation between US and international markets, constantly shifts. This makes it difficult to determine the optimal allocation strategy.
A Contrarian View on International Allocation
The speaker expresses a contrarian view on international investing, suggesting that a primarily US-focused portfolio is sufficient for US investors. While acknowledging the global market capitalization distribution, where the US represents a portion, they believe that allocating a significant portion of equity capital outside the US is unnecessary. If an investor feels compelled to invest internationally, a small allocation (up to 20%) is suggested.
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