Globally diversifying, or investing in a blended allocation of domestic and international stocks, has been widely accepted as a safe and prudent investment strategy that allows you to capture market rates of returns, and also provides downside protection to minimize losses. However, recent market performance has caused many investors to question if that investment theory still holds true and further, if international investing still provides value to their investment portfolio.
Questioning international’s place in a diversified portfolio is a warranted consideration. U.S. stocks have outperformed international stocks as an asset class since the Great Recession of 2008. That strong 15-year track has been impressive.
Compounding the argument against international investments, investors are typically unknowingly biased. Recency bias is a reasoning predisposition that causes many to give more value to the recent history when making decisions, rather than examining a larger set of facts. One might liken recency bias to a trial lawyer giving a strong closing statement that can sway a jury, despite weeks of factual presentation. In the case of the stock market, from 2008 to 2022, the S&P 500 average annualized return was 8.8%, compared to the International Developed Markets Index (MSCI EAFE) of 2.3%; a convincing 6.5% outperformance![i]
However, when you look at the bigger picture, U.S. and International stocks tend to cycle inversely. In other words, when the U.S. stock market is doing well, often it is when international stocks are performing poorly. Vice versa, when international stocks are doing well, domestic stocks tend to be in a slump. Investors forget America’s Lost Decade of the 2000s. From December 31, 1999 through December 31, 2009, the S&P 500 Index had an annualized total return of -0.9%.[ii] If you didn’t hold a portion of your portfolio in international equities during the 2000s, you may have lost money during this decade. Stepping back further, the U.S. has underperformed international stocks (measured by the EAFE Index) during three of the past five decades: the 1970s, 1980s, and 2000s.[iii]
Another common behavioral bias is confusing the familiar with safe, or favoring domestic stocks because we feel secure in our surroundings. Domestic bias can lead American investors to overlook how risky U.S. stocks may be. We should remember that investment returns can increase because the company is posting strong financial earnings, or simply because investors value the company’s future potential growth at a higher multiple, driving the stock price up without current revenues to substantiate that increase. In other words, a stock price can increase for a multitude of reasons other than strong financial standings. As such, increases in domestic stock prices over international should not be assumed to imply stronger revenues, and investors should be reminded that interest or fads can shift quickly.
The cyclically adjusted price-to-earnings ratio, commonly called the CAPE 10 or Shiller PE measures stock price divided by the average ten years of earnings (moving average), adjusted for inflation. The metric is used by many to determine if stock prices are under, fairly, or overvalued. If you examine data back to 1871, the historical CAPE 10 average was 17.0. At the peak of many historical stock markets, when investors felt the most confident, or were willing to pay the highest P/E ratio for stocks, this was actually just before a market crash. In 1999 the CAPE 10 had risen to 44.2, just before the Dot Com crash. In October 2007 the CAPE 10 was 27.3, falling to 13.3 in March 2009, the bottom of the Great Recession. Most recently, the CAPE 10 was at 38.3 in December 2021, declining back to 30.8 as of July 2023.[iv] In other words, just because the stock market is at a high (domestic or international), it doesn’t mean it will stay high forever.
Japan is an example of cyclical growth and the benefits of diversification in a long-term portfolio. In the 1980s, Japan had enviable market growth, outperforming both the U.S. and global markets alike. Recency bias might have caused investors to believe Japan would do well in the near future, and greed might dissuade an investor from diversifying or locking in gains from Japanese investments. However, a subsequent period of stagnation and deflation led to the MSCI Japan Index returning just 0.9% per year from January 1990 through May 2023.[v] During this time, Japan struggled with an aging population and a high debt-to-GDP ratio; struggles the U.S. is currently facing.
Vetting all arguments against holding international investments, there is also the position that when the market crashes, everything crashes, so inverse correlation of domestic and international stocks doesn’t work during a crisis. The data half supports this argument. There are two parts to a market crash, the decline and the recovery. Each are equally important to navigate correctly. Market declines are inevitable, but temporary unless you cash out all your investments at the bottom. Further, the expediency of recovery is important to the longevity of a retirement portfolio, particularly if a retiree is taking distributions. A short market decline like we experienced from COVID in March 2020 can be a blip on the radar of a long-term portfolio and ineffectual on its long-term success. However, extended bear markets can prevent investors from achieving a successful retirement, especially if the decline is during the early years of a distribution portfolio. Global diversification has proven to be a successful strategy for recovering faster from market crashes.[vi] That is because while a global crisis may cause all markets to crash in correlation, the tendency to revert back to inverse correlation resumes during more stable periods, even in our highly globalized modern day society.[vii] The goal of diversification is to architect a portfolio of investments that don’t all move directionally the same way at the same time. When constructed successfully, this allows gains in one sector of the market to offset laggards or losers in other sectors of the market, resulting in net positive average annual returns in a long-term investment window. For example, a Japan only investor would still be awaiting market recovery from the 1990 decline, but a global investor would pick up gains elsewhere during the rebuilding period.
No one can say definitely that we are on the verge of a market shift. Just earlier this year, pundits predicted a recession, and many have back peddled those predictions. The logical conclusion might be that investors should consider diversification as a sound investment strategy for long-term gains. Holding a mix of U.S. and international stocks allows you to capture market returns domestically or abroad during cyclical shifts, which are hard to predict before they happen and difficult to determine how long they will last. Past performance does not indicate future performance, and greed should not outwit logic. Reach out to your Certified Financial Planner™ or CPA with a Personal Financial Specialist credential to see if your investments are on track for the future unknown.
[iii] Bob Veres Insider Information