Revisiting International Diversification

International diversification has come under attack over the last couple of years as both international developed and emerging markets have underperformed U.S. stocks. Figure 1 illustrates this underperformance by looking at the growth of $1,000 invested in U.S. and international developed market stocks over the period from January 2008 through November of this year.

Figure 1: Growth of $1,000 Invested (January 2008–November 2015)¹

As Figure 1 shows, international developed market stocks have substantially underperformed U.S. stocks. The natural question for investors to ask is whether international diversification is still of value, and whether it’s better to increase their allocation to U.S. stocks. The reality is that it’s perfectly normal to have extended periods in which either U.S. stocks outperform international stocks or vice versa. Figure 2 graphs the decade-by-decade returns of U.S. and international developed market equities starting in the 1970s.

Figure 2: U.S. v. International Stock Compound Returns (1970–2009)¹

Figure 2 clearly demonstrates that extended periods in which one asset class outperforms the other is the norm. (Interestingly, it also shows that international developed market stocks have outperformed U.S. stocks three of the four decades.) In a sense, this is diversification at work. But it also shows that investors should expect prolonged periods of one outperforming the other. That appears to be the nature of the relationship (although in this case we’re still dealing with a small sample of decade-by-decade performance). It also demonstrates the danger of looking back over the prior decade and basing investment decisions off of that data. For example, investors who shifted more heavily into international equities in the 1990s after the strong performance of the 1980s were burned by poor relative performance. I think the lesson here (as it usually is) is that sticking with a broadly diversified approach and not deviating from it remains the best course.

Another common question I’ve been asked is why invest internationally given that very long-term data shows the U.S. market has performed the best of any country. As it turns out, we have long-term stock return data for a wide variety of countries dating back to 1900, and that data shows the U.S. stock market has underperformed both Australia and South Africa. So, even viewed from this extremely long-term perspective, there’s not a case to be made for holding only U.S. stocks.

This commentary originally appeared December 28 on MultifactorWorld.com

1. The U.S. stock series is represented by the S&P 500 Index. The international stock series is represented by the MSCI EAFE Net Dividends Index.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results.