Investors can improve portfolio strategy by consistent exposure to both US and non-US equities.
Stock market volatility worldwide is dramatically increasing after several years of relative stability.
Global growth worries, erratic central bank policies and an aging business cycle are but a few reasons causing pundit speculation in the media. Experiencing yet another sharp market decline recently, some nervous investors are reevaluating their asset allocations. But overreacting to short-term news due to investors’ unhealthy monitoring normal market movements may cause a few to inappropriately alter their asset allocations and move to cash, unintentionally reducing returns and so undermining their long-term planning outcomes.
US stocks have substantially outperformed developed non-US developed and emerging markets stocks for several years now. From January 1, 2010, through February 29, 2016, the S&P 500 Index had an annualized return of 11.7% while the MSCI World ex USA Index returned only 2.3% and the MSCI Emerging Markets Index returned −2.3%.
Still, investors should consider benefits from investment allocations outside the US. While many American investors tend to have a strong home bias (as do citizens of most countries), extrapolating recent favorable U.S. returns as the primary input for planning investment allocation decisions may result in future missed opportunities. While non-US developed and emerging markets stocks have been delivering disappointing returns for a couple years, it is important to remember that:
- International stocks offer long-term valuable diversification benefits.
- Recent results, like past performance in general, is not a reliable predictor of future returns.
A WORLD OF OPPORTUNITY IN EQUITIES
The global equity market is huge and represents diverse investing opportunities. As shown in Exhibit 1, nearly half of equity market investment opportunities lie outside the US. While the U.S. dominates the world’s capital markets, developed market and emerging markets still account for 48% of world market cap and represent more than 10,000 companies in over 40 countries. A portfolio investing solely within the US would not be exposed to returns from those markets.
THE LOST DECADE
We can examine the potential opportunity cost from a failure to diversify globally by reflecting on the recent 2000–2009 period. During those years, often called the “lost decade” here in the U.S., the S&P 500 Index recorded its worst ever 10-year performance—a total cumulative return of −9.1% not considering inflation. However, when you look beyond US large cap equities, world conditions were not lost, and in fact some quite rewarding, generating positive returns over the course of the same decade. Further, looking at each of the 11 decades starting in 1900 through 2010, the US market outperformed the world market in five decades and underperformed in the other six.1 This further reinforces our belief why an investor pursuing equity premiums should consider a global strategy: by holding a diversified portfolio worldwide, investors are positioned to capture higher expected returns wherever they occur.
PICK A COUNTRY?
Are there systematic ways to identify in advance which countries will outperform? Exhibit 3 illustrates extreme randomness for 19 different developed market countries over the past 20 years in equity market rankings (from highest to lowest). This graphic reinforces the importance of global diversification: it shows how difficult in practice it would be to consistently execute a profitable strategy exclusively by picking the best country while simultaneously ignoring every other country.
In addition, concentrating a portfolio in any one country can expose investors to costly mistakes by missing big returns in other countries. The difference between the best-and worst-performing countries can be substantial. For example, since 1996, the average return of the best-performing developed market country was 37.5%, while the average return of the worst-performing country was −15.7%. Over the last 20 calendar years, the US has been the best-performing country only twice, and once was the worst performing country.
Diversification means an investor’s portfolio will never result in the best performing outcome. But for wealth preservation purposes, diversification dramatically reduces catastrophic losses potentially associated with investing too much in too few countries. During the last two world wars of the past century, certain markets, as well as certain counties, completely disappeared along with all their investors’ money. Just because something is unlikely, does not make it impossible.
A DIVERSIFIED APPROACH
Over a typical retirement planning horizon, investors can expect strong benefits from consistent portfolio exposure to both US and non US equities. While equity asset classes offers positive expected returns, assets classes of different countries do perform quite differently over short periods. The performance of different asset classes in different countries vary considerable over time, as Exhibit 3 shows. No study exists that sequences of returns can reliably predict the future from past performance. But a diversified investing strategy does help manage risks and captures returns from market volatility more effectively, and in doing so, leads investors to more confident planning outcomes.
1. Source: Annual country index return data from the Dimson-Marsh-Staunton (DMS) Global Returns Data, provided by Morningstar, Inc.