For meaningful diversification, investors need to embrace international stocks, even if the ride has been rough in recent years.
Today begins a two-part series on investing in international stocks. Over the past four years, international investments have done poorly relative to domestic investments. For example, from 2010 through 2013, while the S&P 500 Index returned 15.9 percent per year, the MSCI EAFE Index returned just 8.6 percent per year, and the MSCI Emerging Markets Index returned just 3.2 percent.
The underperformance trend continued through the first five months of this year. This underperformance, combined with poor economic news coming from the rest of the developed world and much of the developing world, has led to an increasing amount of questions I’ve received from investors along these lines: Why should we own international equities given the poor performance and their continued economic problems?
Over the years, I’ve learned that individual investors persistently make the same mistakes. My book, “Investment Mistakes Even Smart People Make and How to Avoid Them,” details 77 of them.
One of the most persistent mistakes is what is referred to as “recency”—the tendency to overweight recent events/trends. That leads to ignoring long-term evidence. And that, in turn, leads investors to buy after periods of strong performance and sell after periods of poor performance—as in “buy high and sell low.” It results in doing the opposite of what investors should be doing, which is to rebalance in order to maintain their portfolio’s asset allocation.
To help you avoid making this type of mistake, we’ll review the reasons you should diversify in general, and why your portfolio should always have a healthy dose of international investments.
Investing involves accepting economic and political risks in return for higher expected returns than you can earn investing in Treasury bills or FDIC-insured CDs. To help address these risks, investors can diversify their investments.
The benefits of diversification are well known. In fact, diversification is often referred to as the only truly free lunch, as, done properly, it allows you to reduce the risk of your portfolio without reducing expected returns. Despite the obvious benefits, when it comes to focusing internationally, most investors have a strong home-country bias. This is true not only for U.S. investors, but it’s also a global phenomenon.
So, let’s first discuss the benefits of international diversification and then discuss why most investors fail to effectively diversify.
Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. There have been long periods when U.S. stocks performed relatively poorly compared with international stocks. The reverse has also been true. Over the long term, returns for the two markets have been remarkably similar.
From 1970 through 2013, the S&P 500 returned 10.4 percent per year and the MSCI EAFE Index returns 10.0 percent. However, it’s important to note that all of the outperformance comes from just the last four years of the period. From 1970 through 2009, the MSCI EAFE returned 10.2 percent, while the S&P 500 returned 9.9 percent.
Given the similarity in long-term returns, the gains from international diversification come from the relatively low annual correlation (0.67) among international securities. While the S&P 500 outperformed the MSCI EAFE for the period 1970-2013, a portfolio that was 60 percent S&P 500 and 40 percent MSCI EAFE and rebalanced annually would have returned an even higher 10.5 percent. That return compares with a weighted-average return of 10.24 percent, so the diversification “bonus” was 0.26 percent.
The logic of diversifying economic and political risks is why investors should consider allocating at least 30 percent, and as much as 50 percent, of their equity holdings to international equities. This is especially important for those employed in the United States, as it’s likely that their labor capital is highly correlated with domestic risks.