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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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I recently viewed a movie titled “The China Hustle”…it’s a documentary showing how American investors are being defrauded by owning bogus Chinese companies.
Good high level summary. For me, my Int’l allocation was a byproduct of my portfolio construction method. It’s about 40%. I would be ok with anything from 0-45% as a US investor, probably 30% if this was my only decision point on equities. You can probably tell I don’t think it’s important to hit a precise AA percentage. How much I save is more important than whether I have a slice of International equities.
In favor of 40-45%:
– Market weight (a global market interpretation of Markowitz and MPT)
– Diversification Benefits (However, these seem to peak at perhaps 30%)
Why now is probably a good time to add International holdings:
– Int’l PE are low vs their own P/E history and vs historical gap to US.
– Tariffs and trade wars will end some day.
In Favor of 0-20%
– Int’l is not needed to hold a diversified portfolio
– The US does have stronger long term returns, generally stronger capital controls
– Most of us will be spending US dollars when we retire. It makes sense to tilt US to avoid disengaging too much from US economic trends.
There is also the argument that US Conglomerates have overseas sales (and vice versa). I don’t think this is a productive consideration, but some do.
an important criteria not discussed here is where the investor is in their investing life cycle. 40% international might make sense in the context of a 100% equity allocation for a 30 year old who has a 40 year investing horizon. The same allocation for an investor in the cusp of retirement would be a Very Bad Idea, imho. but in terms of current valuation ergo future growth prospects are better in Europe, on aggregate. But I also believe that outside the US especially, individual company selection matters!
There is an argument in favor of home bias. Here it is:
https://alephblog.com/2010/01/31/in-defense-of-home-bias/
I do keep about 35% of my stock investments foreign, with half of it emerging. You still have to understand what can go wrong w/international investing.