Durn Furriners

A BURNING QUESTION has only gotten hotter as foreign stocks have lagged disastrously over the past dozen years: Should any of your stock market money be overseas?

Most experts say “yes.” Vanguard Group, for one, recommends investors allocate 40% of their stock investments to foreign markets. In fact, some pundits have smugly derided what they call the “home bias” of those U.S. investors who avoid or underweight foreign stocks. Those stocks currently make up about 45% of world market capitalization.

That smugness has waned considerably since 2007, as the S&P 500 Index has delivered a compound annual growth rate of 8%, versus 2% for MSCI’s Europe, Australasia and Far East (EAFE) index of developed country stocks. That’s a lot of opportunity cost.

If emerging markets were included, the picture would look even worse. Vanguard Emerging Markets Index Fund is up a cumulative 10% over the past 12 years, compared with 29% for EAFE and 163% for the S&P 500. For this article and in the accompanying chart, I compare the S&P 500 and EAFE. The latter index goes back to 1970. By contrast, emerging markets indexes are relatively new, so it’s hard to do long-term comparisons.

The data in the chart suggests investors can’t expect a “free lunch” by diversifying into foreign stocks. That phrase was used by Harry Markowitz, who introduced Modern Portfolio Theory in 1952. According to MPT, combining assets with similar long-term return potential but low correlations can boost portfolio returns while reducing volatility. Trouble is, foreign stocks have offered neither low correlations nor comparable returns for 12 years—and they didn’t in the 1990s, either.

The only sustained period of foreign outperformance since 1989 was in 2002-07. Since the EAFE index’s inception in 1970, the S&P 500’s cumulative return has been double that of EAFE.

But don’t write off foreign stocks just yet.

Take a look at the chart. While annual correlations since 1989 have risen to close to 1—the point at which two assets move perfectly in the same direction at the same time—U.S. and foreign stock performance has diverged widely in each of the three distinct cycles. They’re moving in the same direction most years, but one usually goes much further than the other over longer periods.

The collapse of the Japanese asset bubble dragged down EAFE’s return during Japan’s “Lost Decade” of the 1990s. Indeed, at the market low of 2009, the Nikkei 225 index of Japanese stocks was down more than 80% from its 1989 peak 20 years earlier.

There’s a lesson for us there.

You remember how unbeatable we thought Japan Inc. was? (Okay, I’m showing my age.) Pop stars sang that they were “turning Japanese” and politicians said the U.S. needed to emulate Japan’s industrial policy. Imagine how invulnerable Japanese investors must have felt in the 1980s as they bought up U.S. real estate with inflated stock market gains and with money from their trade surplus with America. Now, think about the fortunes that subsequently were lost by Japanese investors with a strong home bias, as the Nikkei sank while other markets soared.

Could a similar long-term unwinding of inflated valuations and expectations, coupled with economic policy errors, happen in the U.S.? Of course.

While many U.S. investors still buy into the emerging markets story, we’re tempted to think America will forever lap what we see as senescent European and Japanese markets. How exactly could their economies and financial markets ever beat ours again? What’s the story, what’s the catalyst?

The point is, we don’t know and we can’t know. Frankly, the emerging markets story is full of holes, too. A strong argument for diversification: It’s a defense against the unknown—a way to guard against our own hubris when we start to feel confident.

No one can tell you whether foreign stocks will enhance your portfolio going forward. Still, expectations and valuations for overseas markets are relatively low—which is one reason they could trounce U.S. stocks in some multiyear period in the future, as they have in the past.

My suggestion: Set a target percentage allocation for foreign stocks and thereafter regularly rebalance—perhaps annually, every two years or when they move some trigger amount from your target percentage. That way, you take your own emotions, expectations and predictions out of the decision.

What about my own portfolio? Don’t take this as a recommendation, but several years ago I set my target overseas allocation at 38% of my stock investments, with a significant stake in submerging—I mean emerging—markets. I was positioning for a rebound that hasn’t happened yet, and trying to follow expert asset allocation advice. Many a time I’ve been tempted to reduce my stake, but I’ve stuck to it, figuring that any decision I make based on disappointment with past performance likely will be the wrong one.

Forget about betting on the best investment, ignore pundits’ predictions and guru allocations, and—above all—curb your own enthusiasm. Instead, think of diversifying overseas as hedging your bets.

William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles include Oldies but Goodies, Mild Salsa and Weight Problem. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart.

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