FOREIGN STOCKS suffered big losses last week. Vanguard FTSE Developed Markets ETF (symbol: VEA) dropped 6.2% as fears about Russia’s aggression came to a head. Losses were most sharp in Europe—iShares MSCI Eurozone ETF (EZU) plunged 13.3%. For the year, the U.S. stock market is now slightly ahead of international stocks.
Investors often question whether they should own non-U.S. stocks. The common logic—flawed in my opinion—is that domestic firms offer enough foreign exposure because many are multinational businesses. What’s the problem with this argument? It lies with the performance data.
If it didn’t matter whether you held all U.S. or all non-U.S. stocks, you’d expect similar performance from both. In fact, return numbers show they take turns outperforming. That’s a great thing for investors who want the reduced portfolio volatility that comes with broad diversification.
Trouble is, it also creates a huge risk. Investors are all too human and tend to succumb to recency bias, leading them to own too much of whatever has recently performed best. Even without such performance-chasing, many U.S. investors already have a high allocation to domestic stocks due to their home bias.
For now, I won’t get on my soapbox, urging folks to diversify internationally. Instead, let’s see why returns continue to be so different for U.S. and overseas markets.
It’s sometimes thought that currency gyrations drive the diverging returns. There are even funds that hedge foreign-exchange risks, though those hedges come with an added cost. But it seems currency plays a somewhat small role in the performance differential between U.S. and foreign stocks.
Take last year. The U.S. stock market returned 26%, while international markets were up just 8%. The dollar, up a robust 6%, accounted for less than half of the performance gap. Something else was going on.
What was it? The U.S. market has a high weight to the technology sector—28%. Lump in giant stocks like Google (Alphabet), Amazon, Tesla and Facebook (Meta Platforms), and tech is upwards of 40% of the S&P 500. Contrast that to foreign markets, which are just 12% weighted to technology shares. That difference plays a key role in driving performance differences.
The U.S. stock market has returned a strong 301% since May 2008. Foreign shares are up a measly 36% in that time, including dividends. What about the greenback? It’s higher by just 37%. The real drivers of the performance spread between domestic and international indexes are sector differences. Tech stocks are up an incredible 650% over that span. Energy shares, by contrast, returned only 29%. International indexes have historically had a much higher weight in energy.
Further mucking up the analysis are valuation changes. Over the past 15 years, investors bid up growth sectors much more than value and cyclical sectors. That, too, has benefited the U.S. stock market.
My contention: Owning a portfolio of both domestic and foreign index funds, and then periodically rebalancing, makes sense. The two segments go through periods during which one beats the pants off the other. Rather than getting cute and trying to time these inflections, it’s wiser and less stressful to simply own both.