Thus, every 10% increase in your allocation to these stocks relative to U.S. stocks would raise the expected return of the portfolio by 0.32%. In a portfolio with 60% equities, a 50% allocation to international developed-market stocks instead of a 0% allocation would increase the portfolio’s expected return by almost 1% (30% x 0.32%). That’s a dramatic improvement.
That said, it must be noted that international stocks have lower valuations for a reason. They are perceived to be riskier. In other words, the higher expected returns are not a free lunch.
However, adding more international stocks provides diversification benefits. Thus, in my view, increasing your allocation to international stocks is a superior alternative to simply raising your overall equity allocation. Of course, you can consider doing both.
Before moving on, we need to discuss another type of risk. It’s a psychological one that for most investors is very real. It’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, then you’re not exposed to any tracking error risk relative to that benchmark. However, your portfolio isn’t well diversified, being exposed only to large-cap U.S. stocks. Once you diversify beyond that index, 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. In fact, I’ve never met an investor who has asked me about that. However, if you have significant positive tracking error, you can also have significant negative tracking error. When tracking error is negative, it can lead investors to question, and even abandon, their investment plans. And that’s the danger.
Investors subject to tracking-error regret make the mistake I call “confusing strategy and outcome.” In an uncertain world, we should not judge a strategy by the outcome without considering what alternatives might have come to pass.
In other words, a strategy must be judged as correct or wrong before we know the results. If you are going to make this mistake, then, in my opinion, you are best served by forgoing the benefits of diversification.
Emerging Markets Have Even Higher Expected Returns
We can also increase expected returns by increasing a portfolio’s allocation to emerging market stocks. The CAPE 10 for emerging market stocks currently is about 12. That, in turn, produces an earnings yield of 8.5%, and an adjusted real return forecast of 9.4%. Thus, a 10% increase in your allocation to emerging market stocks, relative to U.S. stocks, results in an increase in portfolio expected returns of 0.94%.
Given that emerging market stocks make up about one-fourth of the market capitalization of international stocks, a good starting point for allocating to this asset class is 12.5% of the equity allocation (50% x 25%). Relative to the expected return on non-U.S. developed-market stocks, emerging markets have a 2 percentage point higher expected return.
The caveat here is that the higher expected returns to emerging market stocks aren’t a free lunch. It entails taking more risk. But again, emerging market equities provide an additional diversification benefit. Thus, I consider increasing the allocation to that asset class as superior to increasing the overall equity allocation.
Later this week, we’ll discuss some additional steps investors can take to increase their portfolio’s expected returns. We’ll also provide a warning about risk assets, as well as review two ways to use investment factors to your advantage.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.