Should U.S. investors even try to diversify their stock portfolio internationally? Many are wondering, and it’s easy to see why: international stocks, with few exceptions, have underperformed U.S. equities for quite a few years now — and not by just a little. Over the past 10 years, for example, international equities have lagged U.S. stocks by eight percentage points annualized.
A glimmer of excitement and hope among those championing international diversification happened briefly in 2017. That’s when, for the first time in five years, international stocks beat U.S. stocks — by six percentage points, no less. But that hope was soon dashed, as U.S. stocks finished far ahead in 2018. The same is true so far in 2019.
Those in favor of international diversification now have to justify their beliefs. Gil Weinreich of Seeking Alpha recently focused one of his excellent podcasts for financial advisers on whether “investors [should] finally throw in the towel on global diversification.”
Weinreich argued that investors shouldn’t, and for the most part I agree. Yet I do think U.S. and dollar-based investors need to reduce their expectations for what international diversification can deliver.
Perhaps the strongest argument for giving international diversification the benefit of the doubt is that the past 10 years are hardly exceptional, as shown in the accompanying chart. Notice that, though the S&P 500
is well ahead of the MSCI EAFE index
over the most recent 10-year period, winning over a decade is hardly unique. Indeed, during the late 1990s and the early aughts the S&P 500 was far further ahead of the EAFE for trailing 10-year return.
Yet EAFE eventually came back to life. For six straight calendar years — 2007 through 2012 — this index of international equities outperformed the S&P 500.
Clearly, recent experience appears to be unique only to investors with limited memories and no sense of history. At a minimum, therefore, there is no reason in recent performance trends alone to conclude that this time is different.
That said, it is always possible this time is different — that international stocks will never come roaring back and beat the S&P 500. If that’s what you believe, you must base it on something other than these two categories’ recent relative returns.
Why, then, do I believe investors need to reduce their expectations for the benefits of international diversification? Because those benefits have been exaggerated; it’s important to be realistic so that we do not become unnecessarily disappointed and throw in the towel.
A bit of background is helpful. One of the main benefits of international diversification is that domestic and international equities have relatively low correlation to each other. That means that one is likely to be zigging when the other is zagging, and vice versa. So a portfolio divided between both asset classes should have less overall volatility than either one individually.
The problem with this argument is that the correlation between international and domestic stocks is not constant. International stocks exhibit their lowest correlation with U.S. equities when the latter is in a bull market — precisely when you want diversification the least. International stocks exhibit their highest correlation with U.S. equities when the latter is falling, which is when you do want to be invested in another asset class with a low correlation.
Consider the annual correlations between the S&P 500 and the EAFE index since 1970. In those years in which the S&P 500 rose, the correlation coefficient was 0.34 — while it has been 0.63 in years in which the S&P 500 fell.
This idiosyncrasy of international-versus-domestic correlations is not new. Academic researchers have known about it for years. It’s just that most advisers and investors were unaware of it.
This idiosyncrasy doesn’t mean that international diversification has no benefits. It does, since a 0.63 correlation is still a lot lower than 1.0. Assuming that this correlation holds in the future, and assuming that over the long term international equities produce a rate of return that is similar to that of U.S. equities, then a portfolio divided between the two categories will have better risk-adjusted performance than a portfolio that invests in U.S. stocks only.
It just may not be quite as good as you expected.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. Hulbert can be reached at email@example.com
Source : MTV