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Does International Diversification Still Make Sense?


As a financial advisor, I often get the question, “How is the Market doing?” When someone refers to ‘The Market’ they almost certainly mean the S&P 500, an index designed to track the performance of large U.S. companies. It is based on 500 of the largest publicly traded companies listed on U.S. stock exchanges. The financial media reports on the index’s performance daily. 

And yet, the S&P 500, represents only a third of the value of all global stocks. It does not include any stocks listed on international stock exchanges or U.S. companies that are not large enough for inclusion. 

This U.S.-centric perspective is part of home country bias, or said another way, the tendency of investors to overweight investments in the country where they live. 

Ignoring two-thirds of the available investment opportunity pool is a recipe for long-term underperformance and an unnecessary, uncompensated portfolio risk. Diversification comes with little or no expense and may significantly reduce portfolio volatility. Meanwhile, there is no expected reward for placing too many eggs in one basket. 

Let’s explore a little deeper.

Comparing Decades of Stock Growth

This tendency to favor the familiar is particularly pronounced of late. U.S. stocks have churned out more than twice the average annual return of their international counterparts over the decade ending on June 30th, 2023.

Graph showing monthly stock returns from 2013 to 2023
Exhibit 1: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div). 7/1/2013 to 6/30/2023. Dimensional Fund Advisors.

This fact could lead many investors to throw in the towel on overseas equities. But that would be a classic example of recency bias, the tendency to assign too much significance to recent experiences while assigning too little to those farther back in time. And it could be a costly mistake.

Imagine this blog post was being written exactly ten years ago. Examining the then longest available data set that compares U.S. and International stocks through June 30th, 2013, we would see that international stocks were the long-term winner, by a bit. 

Chart showing US and international monthly stock returns over time
Exhibit 2: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div). 1/1/1970 to 6/30/2013. Dimensional Fund Advisors.

Because we believe in diversification at Abacus, we would certainly have looked at an equity portfolio that included both U.S. and international stocks ten years ago. We could have observed that a portfolio of 60% U.S. and 40% international stocks performed better than either asset class alone. 

Chart showing US and International monthly stock returns compared to 60/40 allocation portfolio returns
Exhibit 3: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div). 1/1/1970 to 6/30/2013. Dimensional Fund Advisors.

Now, if we return to looking at the most recent 10 years to see how international diversification would have served an investor, we observe that while a 100% U.S. equity portfolio was still the winner, diversification blunted the underperformance of international equities quite considerably.

Chart showing US & International Monthly Stock Returns from January 1970 to June 2013Compared to 60/40 Allocation Portfolio Returns
Exhibit 4: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div). 7/1/2013 to 6/30/2023. Dimensional Fund Advisors.

The sad fact though is that we don’t have a crystal ball. We don’t know which of the three portfolios will perform best in the next ten years. We can, however, look through the history of these portfolios, in ten-year increments, to get a sense of the persistence of outperformance by either U.S. or international stocks in the past.

Chart showing US & International Monthly Stock Returns andInternational Wins from 2003 – 2013
Exhibit 5: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div). 7/1/2003 to 6/30/2013. Dimensional Fund Advisors.
Chart showing stock market wins from 1993 to 2003
Exhibit 6: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div). 7/1/1993 to 6/30/2003. Dimensional Fund Advisors.
Chart showing stock market wins from 1983 to 1993
Exhibit 7: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div). 7/1/1983 to 6/30/1993.
Chart showing US and International Monthly Stock Returnsfrom 1973 – 1983
Exhibit 8: DFA Returns Web 2.0 (MSCI U.S.A Index (net div) and MSCI EAFE Index (net div).7/1/1973 – 6/30/1983

Understanding the Data Over Decades

Going back in 10 year increments we can see there has been a ping-ponging back and forth between U.S. and international. This does not mean we are predicting international equity outperformance in the next ten years. Why? 

If the above analysis had been anchored to the first day in the available data set, as opposed to the last, we would have looked at the decades from 1970 to 1979, 1980 to 1989, and so on. In that approach, the decade-by-decade winner pattern is as follows: international, international, U.S., international, U.S.. Back-to-back decades of one asset class outperforming the other occurs. How the results stack up is very dependent on how you slice the data. This means you want to slice the data a number of ways and see what conclusions the different approaches share in common. No one asset class has stayed dominant forever.

What I most worry about as an advisor are clients on the cusp of retirement who, under the influence of recency bias, commit to only U.S. stocks. Inopportune returns are most destructive in the period immediately after retirement when retirees start drawing down assets. Taking a diversified approach is demonstrably less risky, but more importantly, it is baked into the assumptions used in our planning models. If diversification usually produces the middle result, and if your financial projections are based on the expectation of a middle result, your (and your advisor’s) confidence in your financial plan will be greatly enhanced. All good investing is planning driven!

Are American Stocks Exceptional?

Some readers may simply feel that America is unique in its productive potential. Like you, I am a huge fan of our entrepreneurial culture. But I also acknowledge that so much of the difference between U.S. and International stock market performance is a function of currency fluctuations. When the dollar is strong, international assets are less valuable. When the dollar is weak, the inverse is true. Currency fluctuations might as well be random. No one can predict them in advance.

The chart below depicts the I.C.E. U.S. Dollar Index. It measures the value of the U.S. Dollar against a basket of currencies. You can see that currency markets wax and wane over time. And unlike stock markets which rise and fall but which have increased in value over time, currency values are a zero sum game. That is, long-term investors have no expectation of earning a return by holding currency.

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Chart showing ICE Dollar index
Exhibit 9: I.C.E U.S. Dollar Index from 1981 to 2023. CNBC. August 2023. https://www.cnbc.com/quotes/.DXY

A Smarter Approach to Investing

So what is the best way to navigate the unknown? We believe investing needs to be approached with humility. We ultimately acknowledge that while smart minds can observe data and tell stories to explain the past, we can never predict the future. 

At Abacus, this translates into a philosophy that attempts to own everything in the world that there is to own in roughly the proportions that it naturally exists. We are not making a call that we should over-emphasize international stocks because it is their turn. We are simply saying not to avoid them because the most recent history tells a story we don’t like.


Disclosure:

Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your Abacus account holdings correspond directly to any comparative indices or categories.

Please Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your Abacus accounts; and, (3) a description of each comparative benchmark/index is available upon request.

Please Also Note: This material is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Abacus Wealth Partners is not an accounting firm. Please consult with your tax professional regarding your specific tax situation when determining if any of the mentioned strategies are right for you.



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