U.S. stocks have significantly outperformed international stocks in recent years. And U.S.-based companies with operations overseas are major players in the world economy. Does that make international stock diversification unnecessary? Some may believe that is the case but there is strong evidence to support international diversification.
International stocks represent 44.9% of the global market a figure too large to ignore. So, by owning international stock investments, you can diversify your portfolio and take advantage of opportunities by leading companies in emerging and other developed stock markets.
Three main reasons to diversify with international stocks:
1. Market Cycles: The rationale for diversification is clear. U.S. and international stocks often swap positions as performance leaders. It wasn’t that long ago that international stocks led the way over domestic stocks, as shown in the figure below. What might the future hold as leaders potentially turn to laggards? Global diversification gives you a chance to participate in whatever region is outperforming at a given time.
2. Law of Averages: U.S. stocks have had a great run, but will that continue? From a U.S. investor’s perspective, according to research by Vangaurd, the expected return outlook for non-U.S. stock markets over the next 10 years is 8.4%, higher than that of U.S. stocks (5.1%).
3. Potentially Reduce Volatility: Vanguard found that having a mix of international and U.S. stocks historically has reduced volatility, as shown in the figure to the right.
Of course, it’s natural to be concerned about geopolitical risk, but having a mix of U.S. and international can actually reduce portfolio risk. It’s true that correlations have increased between U.S. and International markets as globalization has taken hold. But, including international stocks in your portfolio still carries diversification benefits because of less-than-perfect correlations due to differences in economic cycles, fiscal and monetary policies, currencies, and sector weighting.
U.S.-headquartered multinational corporations alone don’t provide enough exposure because a big chunk of the world economy is still driven by companies with headquarters outside the United States. You may also lose the potential diversification benefit of foreign exchange. That’s because many U.S. multinational firms seek to smooth their revenues by hedging their foreign currency exposures.
Global Stock Biases
Investors faced with bad economic or financial market news are well-served when they maintain long-term perspectives. Remember that:
If there were no risk, potential investment rewards would be small, or nonexistent. “Risk- free” assets typically offer only modest returns.
Markets can change rapidly in response to news, accounting for much of the difficulty in timing trades in an effort to beat broad-market averages.
News providers naturally have a short-term focus. Investors’ horizons should be more akin to those of historians—years or even decades long.
If you look beyond headline risk, you can realize that, historically:
Global stock market indexes have been less volatile than most national indexes.
Investing part of a stock portfolio in international markets has reduced volatility relative to a 100% U.S. stock portfolio.
