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SUPPOSE YOU WERE presented with two prospective investments. On the surface, they look similar, except one has outperformed the other in 12 of the past 15 years. Which one would you choose?
This example isn’t hypothetical. The two investments in question are the S&P 500 and the EAFE Index. The S&P 500 is broadly representative of the U.S. stock market, while EAFE stands for Europe, Australasia and Far East. It’s the most commonly referenced index for developed international stock markets.
Which has delivered the 12 years of outperformance? As you might guess, it’s the S&P 500. In fact, U.S. stocks have outperformed their international peers, on average, for more than 30 years. Because of this sustained outperformance, many investors have long since thrown in the towel on international stocks. That includes, notably, Jack Bogle, the late founder of the Vanguard Group, who said he never owned international stocks in his own portfolio.
In the investment world, the standard disclaimer is that past performance does not guarantee future results. It might seem that investors who limit themselves to domestic stocks are making a fundamental mistake in assuming that U.S. markets will continue to dominate. But those who believe in a domestic-only strategy aren’t just relying on past performance. They cite a number of other reasons U.S. stocks might continue to outperform.
First, the U.S. economy, in addition to being the largest, has some unique advantages. It produces more big public companies—especially in technology—than any other country, and that’s a key driver of our stock market. In Bogle’s words, the U.S. has “the most innovative economy, the most productive economy, the most technologically advanced economy and the most diverse economy.”
By contrast, many other major economies are struggling with challenges of one kind or another. In Japan, the population is shrinking. In France, workers have been protesting for months because the government has asked them to stay on the job a little longer before receiving their lifetime pensions. To be clear, the U.S. isn’t perfect. But on purely financial measures, the U.S. does stand apart, and that’s a reason many choose to stick only with domestic stocks.
In addition, because many of the largest American companies do so much business internationally, an investment in an American company provides a dose of global diversification. Take a company like Microsoft. Nearly half its revenue comes from outside the U.S. For Apple, it’s more than half. For that reason, Jack Bogle and others have argued that there’s really no need to invest in foreign companies to achieve international exposure.
Perhaps the most compelling reason some see international stocks as unnecessary: They’re highly correlated with domestic stocks. Asset correlation is measured on a scale from 0 (no correlation) to 1 (perfect correlation). On that scale, the correlation between domestic stocks and the EAFE index over the past 10 years has been quite high, at 0.88. To put this in context, stocks and bonds have correlations that range between zero and 0.3. That’s why bonds are very effective at diversifying portfolios. International stocks, on the other hand, provide some diversification, but according to this measure, it’s modest.
For all these reasons, it’s understandable why many investors look at international stocks and ask, “Why bother?”
In a recent paper, investment manager Cliff Asness responds to this question. He acknowledges that “international equity diversification has been a losing strategy for more than 30 years.” But he argues that, despite this history, investors should still embrace international diversification.
Why? Asness starts by pointing out that a major driver of domestic stocks’ recent outperformance is that they’ve simply become more expensive. That is, their valuations have risen. On this point, boosters of U.S. stocks are quick to argue that domestic stocks deserve higher valuations—because the U.S. economy is different from that of other countries.
Compare the top 10 companies in the S&P 500 with those in the EAFE index, and you’ll see a clear difference: While technology companies account for six of the top 10 names in the S&P 500, there’s just one tech firm among the top 10 in the EAFE index. This is relevant because technology companies generally carry higher valuations, and that arguably justifies the richer valuation for the U.S. market.
Asness, however, rebuts this argument, pointing out that this valuation gap is a new phenomenon. Domestic stocks haven’t always been more expensive. As recently as 2007, U.S. and international stocks were roughly at parity in terms of valuation. But today, domestic shares are 50% more expensive than their international peers. Because of that, Asness believes U.S. stocks are overvalued and sees international stocks as primed for a period of outperformance.
Asness’s second argument relates to the first. While the correlation data cited above indicate that domestic and international markets tend to move together, they don’t move in perfect lockstep. During periods of market turmoil, they do indeed tend to drop in unison. But over longer periods, Asness’s data shows that international diversification does work. Indeed, international stocks have outperformed in three of the past five decades—the 1970s, 1980s and 2000s.
The bottom line: International stocks don’t provide the same diversification benefit as bonds, but they do provide some benefit, and with returns that are much better than bonds. No question, international stocks have underperformed for a lot of years, but there’s no reason to believe that they’ll always underperform. Indeed, as Asness points out, there’s a key reason to believe recent trends might reverse: the valuation gap that’s developed since 2007.
That’s why Asness says international diversification is “still not crazy after all these years.” I agree, and that’s why I recommend investors allocate at least a portion—I suggest 20%—of their stock portfolios outside the U.S.
What percentage of a stock portfolio should be invested abroad? Offer your thoughts in HumbleDollar’s Voices section.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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What impact does the relative strength of the dollar have on international fund returns? I would think if the dollar became weaker, international funds would go up because it would take more dollars to exchange for the respective currencies. You’d get an immediate bump on your investment, even if the underlying stocks performed the same in their markets. When investing, I always add to the funds that are lagging, so I’ve put a lot in international funds over the years. It’s nice that now I’m finally putting money in the U.S. stock fund because it’s lagging, although the international funds still have a ways to go to catch up.
Perhaps Reversion to the Mean is one other factor to be reckoned with. If U.S. stocks are overvalued and international stocks are undervalued, then reversion to the mean should be expected to narrow that gap, although we don’t know when.
Having said this, we should also acknowledge that America is a hotbed of innovation. We seem to celebrate tinkering, trial and error and exploring new ideas. Unlike some other cultures which frown on failure, if you fail in America you pick yourself up, dust yourself off, and try again. Also, I suspect that there are more venture capitalists in America ready to fund startups than almost anywhere else.
While Americans are as guilty as others of home country bias, maybe a little of this bias is justified.
Why I don’t invest internationally: First, I have no feel for those markets, so I worry I am constantly in the dark about companies and trends. Second, the rules here seem to be better at bringing important information to the surface and maintaining the rule of law in investing. Third, I’ve felt for the last few years that America still tends to drive everything everywhere indirectly over time anyway – other markets get sick when America sneezes. Fourth, despite all our whining about U.S. companies, I believe they are on balance healthier and more robust than firms elsewhere. Fifth, I get enough global exposure for me with the large companies in my S&P 500 index funds who operate around the world. Sixth, I hate the constant possibility of political and military turmoil elsewhere that can zero out one’s investment in a country in one fell swoop. And finally, some of my forays into international markets when I was younger left me with a “meh” feeling. I just don’t feel I need it.
Much as I admire Cliff Arness (so much so that I invest in his Avantis funds) the data say something quite different: international diversification can be of some use but small-cap value is essential. It doesn’t have to be an either/or, but an investor would be far better off with an all-U.S. total stock market/small-cap value portfolio than one like VT (or a typical combination of VTI and VXUS). The differences are not small:
https://www.portfoliovisualizer.com/backtest-asset-class-allocation?s=y&mode=1&timePeriod=4&startYear=1972&firstMonth=1&endYear=2023&lastMonth=12&calendarAligned=true&includeYTD=false&initialAmount=10000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=1&absoluteDeviation=5.0&relativeDeviation=25.0&leverageType=0&leverageRatio=0.0&debtAmount=0&debtInterest=0.0&maintenanceMargin=25.0&leveragedBenchmark=false&portfolioNames=false&portfolioName1=Portfolio+1&portfolioName2=Portfolio+2&portfolioName3=Portfolio+3&asset1=TotalStockMarket&allocation1_1=60&allocation1_2=100&allocation1_3=60&asset2=IntlStockMarket&allocation2_1=40&asset3=SmallCapValue&allocation3_3=40
Warren Buffet stated “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
“If you are not a professional investor; if your goal is not to manage money in such a way that you get a significantly better return than the world, then I believe in extreme diversification. I believe that 98 or 99 percent – maybe more than 99 percent – of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all. That is the way they should approach it.”
– Warren Buffett, speaking to MBA students
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