Swedroe: ‘Free Lunch’ Investing Takes Time To Cook

October 17, 2016

As the director of research for The BAM Alliance, I've been getting lots of calls recently from investors questioning their international equity investments. This hasn't been a surprise, as any time an asset class does poorly, a significant number of investors will question why they own that asset.

One particular inquiry I received addressed the fact that international equities not only had underperformed since 2009, but they crashed in 2008—just when the benefits from diversification were needed most, they failed to materialize. The investor thus questioned the reason for including international equities in his portfolio.

Among the errors discussed in my book, "Investment Mistakes Even Smart Investors Make and How to Avoid Them," is one called recency. Recency is the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to buy after periods of strong performance (when valuations are higher and expected returns are now lower) and sell after periods of poor performance (when prices are lower and expected returns are now higher). This results in the opposite of what a disciplined investor should be doing: rebalancing to maintain their portfolio's asset allocation.

The problem created by recency is compounded when international stocks underperform, greatly increasing the risk that an investor will commit a mistake. This occurs because of another common error: confusing familiarity with safety, which leads to a home-country bias.

To address the question of where to find the benefits of international investing, we don't have to go back too far in time. The problem is that investor memories can be very short—often much shorter than is required to be a successful investor.

A Time Of Crisis And Recovery
We'll begin our analysis by looking at the period that's caused investors to question their strategy of global diversification: 2008 through September 2016. Over this period, the S&P 500 Index returned 6.9% per year, the MSCI EAFE Index returned -0.3% per year and the MSCI Emerging Markets Index lost 1.2% per year. Given these results, it's easy to understand why investors are questioning their strategy.

But no one was questioning this strategy during the prior seven-year period: 2001 through 2007. During this period, the S&P 500 Index returned 3.3% per year, the MSCI EAFE Index returned 8.8% per year and, lastly, the MSCI Emerging Markets Index returned 24.0% per year.

For the full period 2001 through September 2016, the S&P 500 Index returned 5.3% per year, the MSCI EAFE Index returned 3.5% per year and the MSCI Emerging Markets Index returned 9.1% per year. A portfolio allocated 60% to the S&P 500, 30% to the MSCI EAFE Index and the remaining 10% to the MSCI Emerging Markets Index (and then rebalanced quarterly) would have returned the very same 5.3% with just slightly higher volatility (15.6%) than the S&P 500 Index (14.8%).

The table below, covering the five-year period 2003 through 2007, presents an even more compelling case for international diversification. You can be sure I wasn't getting any calls about diversifying internationally during this time, except of course for the ones from investors asking why their allocation to international stocks wasn't higher! (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)



Over this particular five-year period, the S&P 500 Index underperformed by anywhere from 8.8 percentage points per year to as much as 32.4 percentage points per year. However, a tree can't grow to the sky, and such outperformance cannot persist. Inevitably, the high returns produced by international stocks can lead to high valuations and, thus, to lower future returns (and vice versa). And that's the situation we have today, as the data in the following table demonstrates.



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