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U.S. AND FOREIGN STOCKS are highly correlated, with monthly returns that move in the same direction almost all the time. Because of this, some have argued that there’s scant reason to diversify internationally.
But there’s a small problem with this argument: Just because investments move in the same direction doesn’t mean they generate the same return. For proof, consider the past 20 calendar years.
Over that stretch, there were only three years when U.S. and foreign developed market stocks didn’t head in the same direction, either both rising or both falling. That would seem to suggest that foreign stocks didn’t provide much diversification benefit—plus, in each of the three anomalous years, it turns out that U.S. stocks rose, while foreign stocks fell.
Case closed? Maybe not. Next, consider the gap in annual performance. In 17 of the past 20 years, the gap between the total return of U.S. and foreign stocks was six percentage points or greater. In other words, almost every year, there’s a sharp difference in performance. In those years, if you’d owned just U.S. stocks or just foreign stocks, the “no diversification benefit” argument wouldn’t have seemed so convincing. Moreover, these big return differences often persist for a decade or more. U.S. shares have dominated during the most recent decade, while foreign stocks—especially emerging markets—outperformed during the decade before.
How are we doing in 2021? As of Friday’s market close, Vanguard Group’s S&P 500 fund had gained 21.9%, while its international developed markets fund was up 14.1%—yet another year with a sizable performance gap.
Yep. I prefer Int’l Small Caps & EM as a diversifier (knowing that it’s not always going to beat a simple International Developed Fund), but it really probably doesn’t matter much at all as long as you stay the course with whatever choices you make. I believe that over the long term it’s best to have some diversification from the US Market, and have held to that for 25 years. Despite the long string of strong US performance, I’ve done fine.
Back in the 90s, my brother discovered that foreign stocks were highly correlated with the US market on a day-to-day basis. He also discovered he could trade his 401K up until 5 PM EST, and have the trade effective the next day. He could buy the Asia fund at the closing price from 17 hours before.
After running simulations on spreadsheets for a while, he started moving his entire 401K into the Asia fund for one day after big rises in the US stock market. He made about $2 million in four years. Then HR called and told him he couldn’t do this….but he didn’t have to give the money back!
To further emphasize the point of your article, Vanguard’s emerging market fund (VEMAX) is only up 2% this year.