Foreign stocks offer upside value and diversification to portfolios
Let’s face it: Foreign stocks have lately been a disappointment, trailing U.S. shares by more than six percentage points a year over the past five years. Yet the case for diversifying abroad is as strong as ever—and, no, that contention doesn’t rest on the belief that international markets are about to come roaring back, leaving naysayers curled up in the fetal position and weeping quietly to themselves.
Though that would be nice.
So if we shouldn’t hold foreign stocks because they’re about to make us forget their recent dismal performance, why should we own them? Here are six reasons.
First, foreign shares are uncorrelated with U.S. stocks—just not in the way people usually think about it. Yes, on a day-to-day basis, U.S. and foreign stocks tend to rise and fall in sync with one another, so it doesn’t feel like there’s much benefit to owning both.
But just because they head in the same direction doesn’t mean they produce the same annual results. For instance, in 2018, both U.S. and foreign large-cap stocks lost money, but foreign stocks lost nine percentage points more. Similarly, in 2017, both emerging markets and U.S. small-cap stocks posted gains, but emerging markets gained 22 percentage points more.
Second, such performance gaps are even more pronounced if you look at decade-long holding periods. U.S. stocks were star performers not only in the current decade, but also in the 1960s and 1990s. Meanwhile, foreign stocks won out in the 1950s, 1970s, 1980s and the current century’s first decade. Nobody knows which of the two will win in the decade to come. But if you hold only U.S. stocks and they struggle over the next 10 years, there’s a risk you’ll miss out on the markets that could salvage your portfolio’s performance.
Third, U.S. multinationals are no substitute for owning foreign stocks. To be sure, the S&P 500 companies get some 40% of their sales from abroad. But if U.S. multinationals were truly a substitute for owning foreign stocks, they would generate similar performance—which clearly isn’t the case. A key reason: Multinationals tend to hedge their foreign currency exposure, and that exposure is a crucial part of the diversification benefit offered by foreign stocks.
Fourth, foreign shares may be riskier than U.S. stocks or they may have lower expected returns—but, contrary to what a lot of investors claim, both statements simply can’t be true. If foreign stocks really were both lower returning and higher risk, investors would dump foreign shares and pile into the U.S. market, and that selling and buying pressure would ensure both markets have the same risk-adjusted expected return. Got friends who insist it’s foolish to invest overseas, because foreign stocks offer both lower returns and higher risk? You might suggest that, at a minimum, they try to be logically consistent.
Fifth, diversifying abroad can boost your portfolio’s performance—even if international markets have comparable long-run returns to U.S. stocks. How so? Because U.S. and foreign stocks often generate wildly different annual results, combining them can not only smooth out a portfolio’s performance, but it may also deliver a so-called rebalancing bonus.
Suppose you have half your stock market money in U.S. shares and half in foreign stocks. U.S. stocks jump 20% this year but make no money next year. Foreign shares do just the opposite, posting no gain this year but leaping 20% next year. With half your money in U.S. stocks and half in foreign stocks, you might imagine your cumulative two-year gain would be 20%—and, indeed, that’s what you would earn if you had all your stock market money in one or the other.
But in fact, the two-year return on your 50-50 mix would be 21%. Why? The first year, you make 10%, with all the gain coming from the half of your portfolio that’s in U.S. stocks. Because of that strong performance, you now have more than half of your money in U.S. shares, so you rebalance back to your 50-50 mix. The next year, you again make 10%, this time thanks to strong international performance. Do the math and you’ll find that, if you earn 10% for two consecutive years, your cumulative gain would be 21%. There’s a reason diversification is called Wall Street’s only free lunch.
Finally, thanks to the decade-long bull market, U.S. shares are richly valued by historical standards. That isn’t the case abroad—and those more modest foreign valuations could augur well for performance in the decade ahead.
But even if foreign markets perform no better, their lower valuations suggest there’s less downside risk. Investors have priced U.S. stocks as though they expect strong growth for years to come. If growth disappoints, U.S. shares could fall hard. That risk looms less large for foreign stocks. Why? They’ve already disappointed investors—which is good news for the future.
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