Suppose you were presented with two prospective investments. On the surface, they look similar, except that one has outperformed the other in 12 of the past 15 years. Which one would you choose?
This example is not 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 of developed international markets’ stocks.
Which one has delivered the 12 years of outperformance? As you might guess, it’s the S&P 500. U.S. markets, in fact, 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. So 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 why U.S. stocks might continue to outperform into the future.
First, the United States 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.”
In 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 why 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 domestic stocks are quick to argue that domestic stocks deserve higher valuations—because the U.S. economy is different from 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. This is relevant because technology companies generally carry higher valuations, and that is a reason why domestic markets are arguably justified in being more richly valued.
Asness, however, rebuts this argument, by pointing out that this valuation gap is a new phenomenon. Domestic stocks haven’t always been more expensive. As recently as 2007, domestic 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 domestic stocks are overvalued and sees international stocks as being primed for a period of outperformance.
Asness’s second argument relates to the first. While the correlation data cited above indicates 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 United States.
