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Fight That Bias

Mike Zaccardi

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.

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don
don
8 months ago

The ex member of the Chinese national bank I think had to step down as the director of the California employee retirement fund and our defense dept. retirement fund. Finally.

Frank Anthony
Frank Anthony
8 months ago

You don’t make a strong case for foreign stocks. All of the examples provided show US stocks with stronger returns. In addition to currency risk, foreign stocks always have a higher cost basis (certainly for managed funds). I hear the diversification siren call into international all the time but often the numbers don’t back it up. My TSP returns: S&P – 14.59, I (international fund) – 6.56. Now the TSP I fund is arguably not the best international fund to invest in, and certainly sub-international markets perform well, but then you’re picking winner’s and loser’s. Imagine if you had betted on a Russian market dominated fund…. What are the results of a 100% stock vs. 70/30 US/international over the past 10, 15, 20 years???

MikeinLACA
MikeinLACA
8 months ago
Reply to  Frank Anthony

Awesome to see a reader discuss the Thrift Savings Plan. There are a lot of federal employees who read HD. Although TSP information understandably won’t appeal to all readers, those of use who are tied to the plan would love to see occasional commentary / advice focusing on it. Biggest defined contribution plan in the world, Jonathan! Thanks.

Hvltg
Hvltg
8 months ago

Thanks Mike for this information. I always find it difficult to decide on the US to International equity allocation.
Going strictly by the MSCI World index, that allocation might be close to 65 US/ 35 Intl. With respect to total world equity market value it would be closer to 55 US/ 45 Intl. However, more than 20% Intl seems too high to me (probably because of the biases mentioned in the article).
It would be great if you could share your thoughts on this.

Mike Zaccardi
Mike Zaccardi
8 months ago
Reply to  Hvltg

It makes sense to me for a U.S. investor to have way more than 35% in foreign stocks. Here’s why – most folks in the U.S. will benefit through their employment, real estate, and other areas of life when the U.S. stock market does well. Why not shed some of that risk by owning more shares of firms that are not so highly correlated to your overall financial life?

William Ehart
William Ehart
8 months ago

Thanks Mike. Very encouraging to those of us with a good slug of foreign funds through this period of underperformance. I’m thinking of adding to foreign funds, but I don’t know if we’ve seen the full impact of Putin’s war.

Mike Zaccardi
Mike Zaccardi
8 months ago
Reply to  William Ehart

Thanks, Bill! While we all like to avoid market timing, to me, when any of these broad indexes drop more than 20% or so from a high, it’s probably a good time to buy shares for the long haul. But I have similar concerns!

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