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What Is The Correct Allocation To Emerging Markets Stocks In A Diversified Global Equity Portfolio?
Opinions vary tremendously on the topic of how much of an equity portfolio a U.S. investor should allocate overseas. At one extreme is the argument that equity risk is equity risk, especially in a globalized world of multinational corporations and rising global stock correlations, and U.S. investors should have a strong "home bias" since they live in the U.S. and most likely will spend their assets in the U.S. At the other extreme is the view that the U.S. and its currency are in a long-term decline and returns will be far superior on overseas investments.
Ibbotson Associates, a leading asset allocation research firm, recommends that a U.S. individual investor seeking long-term capital growth allocate two-thirds of an equity portfolio to U.S. stocks and one-third to foreign stocks, with 6% of the total equity allocation invested in emerging markets stocks. Indexing specialist Vanguard recommends that between 20% and 40% of an equity portfolio be allocated to foreign stocks.
In addition to deciding how much of an equity portfolio to allocate to foreign stocks, broadly defined, an investor should determine how to divide overseas stock investments between foreign developed and emerging markets stocks. Given that emerging economies are home to 85% of the world's population and 75% of the world's natural resources, and account for 30% of global GDP, emerging markets stocks clearly deserve a healthy representation in a global portfolio.
One frame of reference to determine how much of an equity portfolio to allocate overseas, and to emerging markets stocks in particular, is to examine the composition of global equity indexes (see Exhibit 3). The difference between the composition of the world's total market capitalization and its investable market capitalization is striking. Investable market capitalization (also known as "free float"), which forms the basis for the most widely used market indexes, is the portion of total market capitalization that is freely tradable by investors. It excludes (1) shares held by governments and associated companies and (2) restricted shares held by company insiders. In developed stock markets, investable market capitalization represents 81% of total market capitalization, but in emerging markets the figure is only 38%. Even though market indexes are based on investable market capitalization, total market capitalization is a more accurate measure of economic significance. The data in Exhibit 3 suggest that the average U.S. investor, who typically has the majority of his equity portfolio in U.S. stocks, is underexposed to foreign stocks, and a growth-oriented U.S. investor with a tolerance for volatility should probably allocate 10-20% of an equity portfolio to emerging markets stocks.
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