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:
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
I would just like to say that I am thankful for my 15% allocation to international ETFs since 2006. ETFs like EFA, EFV and Vanguard Emerging Markets have reduced what would have been the value of of my IRA now, and my RMD’s would be significantly larger leading to higher income and and income taxes.
Looking at the value of VT since inception (6-24-098) and comparing to VTI (Total US) one finds that VT has doubled while VTI has increased 3 fold.
I still have these investments, but I think may be a long time before (if ever) my foreign allocation reaches any kind of proportional parity with my domestic allocation.
Excellent piece Adam! Very well balanced and fair. That seems so rare. I’m not completely sure we can say the same about Asness. Much of life comes down to identifying assumptions, and then “picking your poison”. Everyone makes assumptions, but sometimes we’re unwilling or unable to state them. I’m going to poke at a couple of of his statements or your paraphrases of them.
–– “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.”
Why domestic stocks are more expensive is what needs to be explained. First I’d say massive profits are driving them for the stocks that provide most of the returns, and contrary to popular belief the market has always been highly concentrated. There is plenty of data to show the top 2.5% of stocks driven the market since recorded market history (1926). Second, why have P/E’s been rising for decades? I think Micheal Mauboussin is correct that it is probably that in recent decades the intangibles on the most profitable companies that can’t be put on a balance sheet. There weren’t that level of intangibles with commodities of past eras where balance sheets could provide a more complete picture of a business.
–– “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.”
I have no prediction on whether the domestic outperformance will continue. But no reason to believe it could? Come on Cliff. There are some reasons to think it could.
Here is where I state what I think are some hidden assumptions in Asness’ view. Isn’t the reason Cliff thinks this his faith in MPT (Modern Portfolio Theory)? Which is the idea on the never-ending quest to come as close as possible to the perfect investment: high returns and low risk. The tenets of MPT now underpin the conventional wisdom on how to achieve that. I’m skeptical for reasons I won’t bore y’all with now.
Bottom line is that if I had a firm faith in the tenets of MPT as I’m sure Asness does, and the concomitant idea that diversification is “an almost free lunch”, then yeah I’d diversify internationally. BTW, if ‘almost’ isn’t the weasiliest of words I don’t know what. But these guys say it with a straight face. Because MPT! I think unstated faith of the average financial advisor in MPT drives much of what they advise. Then they turn around and impugn the intelligence of those who disagree by claiming it is mere blind faith that “the US economy is different”. When they recognize their own blind faith maybe I’ll start listening to guys like Asness.
Just buy the total world index (VT as the ETF from Vanguard) and you don’t have to worry about it.
Much like I wouldn’t overweight a portfolio to one sector over another, I wouldn’t overweight domestic or international over what the market has decided.
We American investors may suffer from a heavy dose of recency bias in addition to the natural tendency to love and favor most what’s familiar.
Diversification and better value (buying more dividends for less) are two pluses for international stocks which you noted, but there are more which may matter over the next 50 years:
1: While America and its industries currently benefit from owning the world’s reserve currency, that could change as it has before.
2: The greatest population growth in this time will happen in Asia and Africa, not the U.S. or Europe. Too: other countries are blessed with abundant resources.
3: The U.S. may not stay in the global pole position for innovation; there are signs the change is already happening.
I don’t believe America’s best days are behind her but still humbly aim for the global market allocation, currently ~60% US/40% ex-US.
> The greatest population growth in this time will happen in Asia and Africa, not the U.S. or Europe. Too: other countries are blessed with abundant resources.
David, I read this as a suggestion that we no neglect not only ex-US in general, but Emerging Markets in particular, since Europe and Japan, as developed international economies, dominate ex-US funds. That’s a lot to o stomach as emerging markets have historically taken investors on a wild ride–but if that is your suggestion, I do agree with you from the diversification point of view.
The question as always is what is someone’s age? It realistically may take 20+ years for Asia and Africa to begin to realize the economic potential in its population. For someone who may not live that long, such speculation is more academic than actionable.
The best portfolio is the one you can stick with thru the rough patches. Emerging markets (EM) exposure may not be suitable for everyone. I think about the long-term demographics to remember that the EM piece of my investments is a long duration slice of the pie. To keep some of the EM volatility out of sight, I hold it in VEU/VFWAX where its ups and downs are averaged in with other ex-US geo slices which may move differently when EM stocks drop. You can also get EM exposure with VT/VTWAX as Nate suggests, averaging it further in with all of the world’s publicly traded stocks, a very simple solution.
Good points David. I would also add that while holding a portion of our portfolio in an EAFE index (which I do) gives some diversification, it isn’t give as much international diversification as one might think, or at least not in the way we might think. It seems the EAFE is dominated by large companies in a similar manner as the S&P 500, who also do considerable business in the US. So, to really give our portfolios a more international tilt, something like an international emerging markets and/or small-cap fund would more fill the bill.
Personally, I like holding some of my portfolio in the EAFE, as its valuations seem more favorable right now than many US indexes, while many of its largest companies have US-like exposure to world markets. As for those emerging markets and small cap funds, I’m not really on board with those right now, but I can’t fault the logic of those who choose to go that route. The main thing is, as Adam has preached so many times, to take a good look under the hood of any fund you are considering, and know what you are holding, and why.
An addendum to Adam’s column: Folks often look at the close correlation between U.S. and international stocks, and the fact that both U.S. and international markets are dominated by multi-nationals, and declare the diversification benefit limited. But if the diversification benefit is so limited, why are we all so aware of past performance disparities? Consider two points: 1) while U.S. and international stocks often rise and fall together, the differences in annual returns are often substantial; and 2) while U.S. and international stocks are closely correlated, we have decade-long stretches when one easily outpaces the other. It strikes me that U.S. investors are constantly looking for reasons not to invest abroad. I fear this reluctance to diversify internationally could come back to haunt many investors.
I wish Dimson/Marsh/Stanton would release an affordable, updated edition of “Triumph of the Optimists” in the U.S. The current edition, based on data from 1900-2000, is a gem with many insights softening arguments for U.S.-only investing.
Not to mention the long history of debt defaults and asset seizures that have made foreign investments risky.
The USSR was the world’s largest experiment in a socialist economy. Now, the EU is. What happens to their economy if the US grows tired of funding their defense? Had Moscow invaded the Ukraine one administration sooner, its entirely possible that we’d have the answer now. You can dismiss this as politics but it’s realistic and the threat to investments is all too apparent.
1) The way Russia has struggled against a single tiny country, I seriously doubt they would ever be dumb enough invade a NATO backed country.
2) The world is much bigger than Europe and Russia. Another player such as Asia, Africa, India, or South America could surprise in future market returns. Am I predicting? No, I just think the market can more accurately price these things than I ever could. (Which is why I own a whole world index fund.)
From 1900-2000, the US stock market was #4 for real stock returns, trailing Sweden, Australia, and South Africa. No one knows which countries will lead this century but you don’t have to guess with your investment in a whole world index fund.
Fascinating stat about Sweden, Australia, and South Africa. But the devil is in the details and I’d need to see sources. I’m not sure there is good data in the US before 1926, and a lot happened in the 1/4 century between 1900-1926. During part of this period the British Empire was still going strong (Australia & South Africa) and WWI would be highly important contexts to interpret the data.
In the past, one of the factors that kept me away from total global index funds were their rather lofty fees, as compared to traditional domestic (and international) index funds. But in the last several years, funds such as Vanguard’s VT have gotten much more competitive in this regard, and are now worthy of serious consideration in my view.
VT expense ratio is a very low 0.06%. If one were really wanting to skimp, they could buy the two requisite components that make up VT separately: VTI (US at 0.03% expense ratio) and VXUS (international at 0.06% expense ratio). That would lower the expense ratio more, but the ease of just buying VT is worth the few extra pennies to me.
(Note: If held in a taxable account, there might be a slight tax advantage to holding them separately as well, but when I calculated it, it was never worth the extra effort to me.)
Tax advantage due to ability to tax loss harvest or something else?
Randy, it’s actually from the foreign tax credit that one receives. (Because some elements are already taxed by foreign governments when you file US taxes you get a credit.) VT used to get the same treatment but ever since it has been >50% US it no longer qualifies. I am not an expert, but you can find lots of discussions about it on bogleheads.org message boards and Reddit, such as this one. The example calculated by a responder in that link shows for 2020, at $100,000 invested in VXUS, one would have received $2,430 in dividends and been able to claim $241 in foreign tax credits, so around 0.241%. Some people hold the VTI (US) portion in their non-taxable account and the VXUS (international) portion in their taxable account to maximize this, but you can see it is rather small unless one has a large amount invested.
Yes, expense ratios like that have got to be a broker’s nightmare! The ultimate in diversification, for pennies on the dollar compared to an actively managed fund. Investors have never had it so good!