May 31, 2020
Why Even Consider Investing In International Stocks
Before getting deeply into a discussion regarding the how’s and why’s of including international stocks in a well engineered portfolio, its probably best to go back to square one and a primary concept of intelligent investing: diversification – not putting all of one’s eggs in any one basket.
In order to better understand diversification it’s best to revisit (briefly) perhaps the premier theory providing the foundational construct, which is largely accepted within the investment community for building an intelligent, long-term portfolio: Modern Portfolio Theory (MPT). Without getting deep into the weeds and esoteric mathematics, at its simplest MPT is nothing more than an explanation of how diversification can enhance portfolio performance. Easily understood as: when you combine non-correlated asset classes (meaning they don’t all move the same way at the same time and an asset class being such as large company US stocks or small company foreign stocks, etc.) while inherently risky in their own rights, when combined in a portfolio they will lower the overall risk and improve the long-term expected rate of return. So what does this have to do with investing in foreign stocks today?
If we go back to some recent history, like the late 90’s when the dot.com and technology stocks along with large US company growth stocks were all the rage, we heard such statements as “cash is trash,” “Value is dead,” “foreign stocks are for idiots” and “investing in small company stocks (especially foreign ones) is stupid.” This appeared to be true – until 2000 when it no longer was. The US stock market crashed (dot.com/tech bubble) and as Warren Buffet was famed for saying: “when the tide goes out, that’s when you find out who’s swimming naked!”
So how did portfolios do that perhaps looked stupid in the short term? Pretty darn smart in the long as it turned out! Most well diversified portfolios managed to weather the bear market in really good shape. So much so that foreign stocks tripled until the next bear market in 2008. What about those high flying, domestic growth stocks? The period from 2000 – 2009 was known as “the lost decade.” Large company domestic stocks as represented by the S&P 500 managed a negative -9.1%! Well cynics might say this was a “one of” period. However, if you go back to the early part of the last century, we have had eleven decades of performance to measure. In five of those decades US stocks outperformed foreign stocks but in six of those decades foreign stocks outperformed US stocks!
If we look at the last few years US stocks have clearly outperformed foreign stocks. But, to extrapolate that into the future is falling into the statistical trap known as recency bias, which is the psychological state of only remembering the recent past and using that to judge what will occur in the future. If we use as a simple example that of coin flipping, if we flip and the coin comes up heads five times in a row, that does not change the fact that the odds are still 50/50 on the next flip of the coin – regardless of how many times in a row heads may have come up.
Returns are random – despite guru’s crystal balls and exotic statistical analyses, nobody can predict which will be the best performing markets in the future. There are too many random and unpredictable variables to be able to have confidence in any prediction – which of course is the rationale behind diversifying one’s portfolio (MPT aside). So let us take a look at twenty years, going back to January 2000 through April 2018:
S&P 500 191.58%
US Large Value Index 203.48%
Emerging Market Index 315.51%
International Small Co Index 376.82%
Emerging Markets 432.73%
Emerging Markets Value Index 601.48%
Note: Past performance is no guarantee of future performance.
As the foregoing illustrates, nobody knows for sure which asset classes will outperform, the returns come when they come, but in the long-term diversification, including the non-correlated diversification provided by foreign stocks (in varying asset classes such as above) can serve to provide substantial benefits to long-term portfolios and investors who are willing to be patient and look beyond the last few year’s performance of any one asset class – including that of the S&P 500!