The broad US stock market has outperformed the broad international stock market for each of the past three years. Not only that, the broad US stock market has beat the international stock market in six of the past eight years. This has a lot of investors asking themselves, does it really makes sense to diversify internationally?
I think it helps to put this performance streak in perspective. Since 1970, over one, three, five and seven year periods, it has been pretty much a coin flip whether the US stock market beats the international stock market. Performance is pretty much a coin flip over even longer terms as well – if you consider the 11 decades starting in 1900 and ending in 2010, the US stock market outperformed in 5 decades and underperformed the other 6.
Since 2009 the US has clearly been a big winner, besting the foreign shares by 100%. But performance differences can go the other way as well, consider the time period in the late 1980’s when the international stock market outperformed the US market by 250%, driven by the dominance of Japanese stock prices.
From there, the US took over and dominated international returns by almost 200% in the 1990’s. The decade that followed sometimes called the “lost decade” is a great example of when the performance difference favored international stocks. From 2000-2009 the S&P 500 Index recorded its worst ever 10-year return of negative 9.1%.
Meanwhile, the MSCI World Ex USA Index, an international stock index that does not include the US, returned a positive 17.47%.
Though return differences can be huge, whether US stocks or International stocks will be the star performer in any particular period is impossible to know in advance. This applies to all asset classes. Though it would be nice to be able to predict which asset class will be the winner in any given year, this is simply impossible to do.
The chart below helps demonstrate this point by ranking the returns of several different asset classes by their performance each year:
Each year has its winners and losers, but which asset class performs well over a given year is completely random. The only way to ensure you will hold the winner asset class is by being diversified, holding every asset class, all the time. In this case, that means constant commitments to both US and International stocks in the stock portion of your portfolio.
The real reasons to invest internationally are less about performance and more about big picture principles of diversification. Let’s start by looking at the chart below that shows each country’s percentage of the world market capitalization.
The countries are plotted approximately where they appear on a map, and the size of each box corresponds to that country’s market capitalization.
As you can see, the United States makes up about half of the world’s market capitalization. This is a lot for one country, the most of any by far.
However, this also means that by investing only in the United States you are ignoring almost half of the investable universe! By investing outside the US you have many more investment options, in different countries and in different individual companies. Taking advantage of this larger opportunity set results in considerably more opportunities to diversify your portfolio.
The importance of international diversification is something that advisors should articulate to their clients. When I was researching this topic for this blog, I came across a video from Dimensional Fund Advisors that shows some of their financial advisors (like us) talking about international diversification that I felt was worth sharing.
They put their own spin on some of the principles I just mentioned and cover a few others as well.