Nine years ago, U.S. large-company stocks were among the world’s most loathed investments. Over the prior decade, they had lost money, while pretty much every other investment category—U.S. bonds, shares of smaller U.S. companies, real estate investment trusts, emerging market stocks, gold, developed foreign markets—had posted gains.
How quickly we forget.
Many investors suffer from so-called recency bias, the tendency to assume that the future will look like the immediate past. We take the investments that have lately performed best and extrapolate those gains into the future. It’s little wonder that so many investors today are convinced that the large-company stocks that make up the S&P 500—and especially large-company growth stocks like Alphabet (Google), Amazon, Apple, Facebook and Netflix—will continue to shine.
This recency bias is made even worse by another pervasive mental mistake: home bias. We find it comforting to own investments we’re familiar with. That explains why so many everyday investors end up with big stakes in their employer’s stock, local companies, and the shares of corporations whose products and services they use. At the same time, we find it uncomfortable to own foreign investments—and it’s doubly uncomfortable when they have lately performed poorly.
Part of the blame, I believe, lies in how we think about portfolio building. We tend to view U.S. stocks as our engine of investment growth, and then we add bonds, foreign stocks and other financial products as we look to manage risk and boost returns. What if U.S. stocks produce dominating returns? Suddenly, adding these other investments seems like unnecessary tinkering.
Make no mistake: Overseas stock markets have lagged over the past five years, climbing just 4.4% a year, while the S&P 500 has soared 14%. Are you questioning why you have money invested abroad? Consider a trio of data points:
- Keeping money close to home may feel safer, but it doesn’t always pan out that way. In 1989, Japan easily ranked as the world’s largest stock market. Since then, the Nikkei 225 has fallen some 40%. If you were a Japanese investor leery of investing abroad, it’s been a rough 29 years.
- U.S. stocks may have beaten overseas markets in the current decade, but they don’t always reign supreme and actually lag half the time. Foreign stocks had the edge in the 1950s, 1970s, 1980s and 2000s.
- At the end of 2018’s third quarter, U.S. stocks were trading at a cyclically adjusted price-earnings (CAPE) ratio of 32. CAPE compares current share prices to average inflation-adjusted earnings from the past 10 years. According to StarCapital.de, only two countries were more richly valued: Denmark and Ireland. On average, developed European countries were trading at less than 19 times their cyclically adjusted earnings.
I’m not predicting that the U.S. will be the next Japan, that the U.S. stock market will crash or that foreign stocks are destined to outperform U.S. shares over the decade ahead. But it’s important to realize that there is (pun intended) a world of possibilities—and it’s dangerous to bank too heavily on any one investment.
That brings us to three core investment principles. First, markets are reasonably efficient, meaning they reflect all currently available information. Everybody knows that the U.S. economy is humming along, with unemployment at record lows and corporate profits soaring, in part because of recent tax cuts. Everybody also knows that Japan and many European economies are in a deep funk.
In other words, there’s a good reason the U.S. stock market is one of the world’s most expensive. But to justify those valuations, U.S. corporations will likely need to continue generating A+ results. What about foreign stocks? They’re priced for disappointment, and even a B- economic effort could trigger a big rally among international markets.
Second, risk and return are joined at the hip. If we take more risk, we should earn higher returns—though those higher returns aren’t guaranteed. This is the why stocks ought to outperform bonds over the long haul, and why smaller-company shares should outpace larger companies.
Yet many investors today believe that U.S. stocks are both safer than foreign shares and also pretty much guaranteed to notch higher returns. This cannot be the case: If U.S. stocks really offered that sort of investment free lunch, investors would pour money into U.S. shares, driving up their price and eliminating the advantage.
I think it’s reasonable to assume that U.S. and developed foreign stock markets are about equal in risk, which means they ought to generate similar returns over the long run. But if I were forced to choose, I’d probably declare that foreign stocks are riskier. Overseas economies are shakier. Property rights are weaker. Corporations are less transparent. Feel the same way? Then you ought to expect higher long-run returns from foreign stocks.
What’s the third core investment principle? It’s perhaps the most important: Nobody can forecast which way financial markets are headed next. That’s why we should focus instead on things we can control, like our investment costs, our portfolio’s tax bill, our own (sometimes foolish) behavior and the amount of risk we take.
And when it comes to managing risk, nothing is more crucial than diversification. If we own a globally diversified portfolio, we will always own the best-performing stocks—and we’ll always own the stinkers. That might sound like a mixed blessing. But in truth, it’s a winning strategy.
If we’re globally diversified, we garner two huge benefits. First, we have a portfolio that’ll be less volatile than if we focused our money on just one part of the global stock market.
Second, we don’t run the risk of getting it badly wrong and missing out on big market gains. Remember, the aim is to accumulate enough for retirement and our other financial goals. If we save regularly, diversify broadly and hang on for the long haul, we have an excellent chance of doing just that. What if we bet on just one country’s stock market? Our chances aren’t nearly so good.