Give in or give up - TheStreet

Accepted financial theory of the past twenty years has been that an investor must diversify to maximize yield on his portfolio. Real risk disbursement doesn't just mean among different stocks or among different instruments but also geographical diversity.

While financial experts know why an investor must diversify among different markets and economies, most of the worlds investors prefer to put their money in their local stock exchanges, currencies and banks.

In the financial world that is known as "home bias" and it means the investor's natural tendency to keep his money close to home, with the bank clerk he knows, in the local stock exchange and in local mutual funds. Americans buy American stocks, Germans buy German stocks and Israelis buy Israeli stocks.

The information revolution and the outbreak of the Internet began in the past few years to budge the natural home bias. Institutional and private investors the world over started spreading their portfolios around the globe. In the past decade, foreign investment in American stock exchanges has brown seven times over to $2.5 trillion, about 15% of the total U.S. market capitalization. American investment on foreign exchanges also grew by hundreds of percent to reach $4 trillion.

In contrast, Israeli investors remained loyal to the local exchange. The tax exemption on investment in Israeli shares distanced them from the foreign shares and the high interest on shekel deposits kept their money in local banks.

Israeli investors great confidence in the local economy was particularly evident in recent years as Bank of Israel and the Ministry of Finance completed the currency liberalization that allowed any Israeli to convert any sum from shekels to foreign currency and take it out of Israel.

Anyone who expected a great flight of foreign currency from the economy as a result of the opening of the markets was proven wrong. Israelis continued to hunker down in the shekel and overseas bank accounts continued to be mainly a tool of the major tycoons.

It looks like that era is over. In the past year, many Israelis have begun to distribute the risk in their portfolios by moving money abroad. In the past half year alone, Israeli individual investors have deposited $100 million to $150 million a month in foreign bank accounts.

And not just individuals: insurance companies received permission last year to increase the foreign investment component in their portfolios and they are methodically increasing investments on foreign stock exchanges. There are those who estimate that the insurance sector will have completed the transfer of 10% of its assets abroad within the year.

In addition, Israeli mutual fund managers have begun offering the public new funds that specialize in foreign securities mostly European and American bonds. These funds have been successful and raised billions of shekels in the past few months. Anyone who got into these funds at the beginning of the year has already posted nice profits due to the shekel devaluation.

Although geographical diversity is a wise financial move at almost any time, it is clear that the recent trend of taking money out of Israel indicates loss of confidence in government policy.

Since public confidence in treasury policy began to erode, government bonds have collapsed rapidly and are now trading at annual return on redemption of 10%. Theoretically, there is a fantastic investment opportunity here: the Israeli government now offers interest three to five times higher than that on the dollar or the euro. However, where there is no confidence, interest gaps are nearly meaningless and investors prefer deposits and bonds in foreign banks that operate in strong economies with responsible governments.

This is not the first time in history the Israeli public has lost confidence in its government, but it is the first time this has happened when the capital and currency markets are completely open and the public can act transfer its money to countries it believes have been blessed with more responsible governments.

The outflow of money from Israel and dealers estimates that this is an ongoing phenomenon, is one of the primary reasons for the foreign currency demand of the past few months and the continuing shekel devaluation.

It's unlikely this is a passing phase or that it can be stemmed with an interest rate hike. Israeli investors will continue to put a large chunk of their money in international capital markets in the next few years.

The Rabinovitch committee recommendations could support this transfer, as they will gnaw at the local markets' greatest advantage their tax exemptions.

The managers of foreign investment banks and commercial banks that opened branches in Israel in the past few years planning to take Israeli companies public abroad and finance the Israeli business and retail sectors have recently begun to understand that the direction of the money flow has turned around. Instead of bringing money from abroad to finance the Israeli business sector as they did in the past five years, many of them plan to open asset and portfolio management activities abroad for Israeli individual and institutional investors.

Israeli investors' ability to vote 'no confidence' in the government in such a simple and rapid manner could be the most important economic event of the coming year and could impact Israeli economic policy more than any other thing.

The government has only two options. Either give in to the markets, cut the budget deficit and lower taxes, thus convincing investors that it is advisable to keep their money where they live.

Or give up, scrap the whole plan, cancel currency liberalization and declare the Israeli economy under its democratically-elected leadership unready to join the free world.