As U.S. stocks have outperformed developed international and emerging-markets stocks in recent years, more people are questioning the benefit of investing outside of the United States. This is an important question, and we acknowledge that owning foreign stocks has been an unsatisfying experience over the past several years. Moreover, given some of the current economic and geopolitical forces, it can appear likely to continue this way.

The first key point is to remember that equity markets and asset classes in general go through cycles and it is unwise to extrapolate recent performance far into the future. As shown in the chart, in the market cycle that followed from 2002–2007, international stocks beat U.S. stocks by a wide margin, and emerging markets did even better, outperforming the S&P 500 by more than 20 percentage points annualized.

Because markets move in cycles, there will always be periods where global diversification doesn’t appear to “work.” From a long-term standpoint, the case for global investing remains compelling.

Broader Opportunity Set

Holding a globally diversified portfolio provides access to a much broader investment opportunity set, which should, in turn, enhance portfolio performance over time. In 1970, U.S. GDP accounted for 47% of the world’s total economic output (GDP). Today it is closer to 20%, while emerging markets now comprise roughly half the world’s total output. Likewise, in terms of market capitalization, in 1970 the U.S. market comprised 66% of the world’s total stock market value. By 2013 it had declined to roughly 49%, with emerging markets comprising 11%, and the remainder in developed international markets. If an investor chooses to only invest in U.S. stocks, they are excluding themselves from over half of the world’s total investment opportunity set. Moreover, they are limiting their opportunity to invest in some of the world’s most attractive companies domiciled outside the United States.

There are other factors that support the case for continued strong relative economic growth for emerging markets in particular. A high proportion of the world’s population is in rapidly developing economies and these are becoming a more significant force in the global economy. Emerging markets will likely derive similar productivity benefits as the developed world did through its industrialization over the past two centuries. However, this productivity improvement in emerging markets is happening at a more rapid rate, in part due to the adoption of Internet and communications technologies.

In addition, emerging-market economies are typically less burdened by debt than the developed world.  Demographics are generally more favorable for growth (younger and more underutilized populations). These factors support the idea that emerging-market economies are likely to grow at a superior rate relative to developed markets economies for an extended time period.

Diversification

A second important reason for owning a globally diversified portfolio is that it should provide a much smoother ride than just being invested in U.S. stocks alone. By diversifying investments across different asset classes and securities that react differently to market and economic conditions investors are able to effectively reduce overall portfolio risk and volatility over time. A diversified global equity allocation should produce better longer-term risk-adjusted returns than the stocks of any single country held in isolation.

This has historically been the case.  Looking at rolling 10-year periods since 1970, a global portfolio (comprised of 60% S&P 500 and 40% non-U.S. stocks) generated an average return of 12.5%, beating the S&P 500’s average return of 11.3%. (The results were similar using rolling five-year periods.) In addition, a global portfolio beat the S&P 500 in 71% of the rolling 10-year periods.

Global diversification enables us to create portfolios that should perform at least reasonably well across a wide range of possible scenarios and outcomes. But it takes discipline to be a long-term diversified investor, because any given asset class can lag in any given year or even over multiple years, and with 20/20 hindsight it is easy to start questioning why you owned those particular assets in the first place.

Valuation Matters

In addition to the belief in the long-term benefits of investing globally, valuation matters and is a key component of future market returns—and future returns are all that matter from this point forward. Therefore, there are times when it makes sense to over- or underweight markets or asset classes to tilt the odds of success more in your favor. Depending on a company’s stock market valuation relative to its business fundamentals and future earnings potential (i.e., the price you are paying in the stock market to capture the potential value of that particular investment) the expected returns for many companies in non-U.S. markets may more than compensate an investor for those types of risks. Whereas even if the United States is the strongest and most stable economy in the world, that doesn’t mean its stock market offers the best current risk/return profile.

 

David Trent is the Founder of Trent Capital Management in Little Rock, AR. Questions or comments? Check out David’s GuideVine profile to watch his videos and learn more.

Categories: Investments