Swedroe: Go International To Be Diversified

For meaningful diversification, investors need to embrace international stocks, even if the ride has been rough in recent years.

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.

Why Diversify?

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.

To obtain the greatest diversification-benefit exposure to international, stocks should be unhedged from a currency perspective. While hedging currency risk does reduce the volatility of international investments, it has the negative impact of increasing the correlation of returns to U.S. equities.

Given the benefits, why do most investors have very low (10 percent or less) international allocations? Two explanations stand out. The first is that investors confuse the familiar with the safe. And defying the economic logic that risk and expected return are positively related, while investors think their home countries are safer, they also expect them to have higher returns.

Unfortunately, familiarity provides an illusion of safety. Clearly not all countries can be safer, nor can they all have higher expected returns.

The second explanation is what’s known as “tracking error regret.” Tracking error is defined as underperformance versus a benchmark. Most often, the benchmark is a commonly referred-to index such as the S&P 500. If your portfolio consists solely of an investment in an S&P 500 Index fund, you’re not exposed to any tracking-error risk.

However, your portfolio isn’t well diversified, being exposed only to large-cap U.S. stocks. Once you decide to diversify beyond that index, in order to gain the benefits of diversifying economic and political risks, you must accept the risk of tracking error.

Most investors never question a divergence in their returns from a benchmark when it’s positive. However, if you have significant positive tracking error, you can also have significant negative tracking error. And when tracking error is negative, the danger is that it can lead to investors questioning—and even abandoning—their investment plans.

So, we’ll take a look at the problem tracking error creates when you add international investments to your domestic portfolio. The table below illustrates tracking error risk by comparing the performance of a portfolio with a 100 percent allocation to the S&P 500 Index to the performance of a portfolio with a 60 percent allocation to the S&P 500 Index and a 40 percent allocation to international stocks using the MSCI EAFE Index. The table covers the 10-year period 2004-2013.

Sources: Standard and Poor’s (S&P 500 Index), MSCI Barra (MSCI EAFE Index)

A) S&P 500 (%)

B) MSCI EAFE (%)

C) 60% S&P 500/40% MSCI EAFE (%)

D) Portfolio Return Minus Return of S&P 500 (%)

While investors are always pleased when there’s positive tracking error—as there was in each of the first four years of the period—many cannot tolerate underperforming their peers by significant margins when the tracking error turns negative, as it did in four of the six succeeding years, and is doing so once again in 2014. They begin to question why they invested in what they see as those risky and poorly performing stocks.

But the truth is this: Unless investors can tolerate negative tracking error, and rebalance when appropriate, an international allocation will not be of much value. In fact, it can be a real negative because plans will be abandoned after periods of poor performance, selling low after incurring the losses.

Assuming investors can stomach negative tracking error, in my next post, I’ll explore reasons to increase or decrease international exposure.

Larry Swedroe is a director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.