It’s been a long time since globally-diversified investors could point to their foreign stock allocations with pride.
Non-US stocks, both developed and emerging markets, have underperformed the S&P 500 for over a decade. When I talk to prospective clients about how they should invest for their long-term goals, many question the wisdom of continuing to invest overseas. The US has done well for so long, the thinking goes, why shouldn’t we just continue to ride the winning horse? Let’s take a deeper dive into the wisdom of owning foreign stocks.
First, let’s revisit market returns since 2010, through year-end 2020. We see US stocks, as represented by the S&P 500, have had well-above-average returns. The +14% per year return is about 40% higher than it’s long-term averageof 10% dating back to 1926. International developed (MSCI World ex USA Index) and emerging markets (MSCI Emerging Markets Index) had far worse returns, gaining just +6.0% and +5.3% per year.
But if we look back over previous decades, we see that the S&P 500 is not always the best relative performer. We have data going back to 1970 for international developed stocks. When we look at the four decades (ten years ending 1979, 1989, 1999, and 2009), we find that the S&P 500 only outpaced international stocks once. In three of the four previous decades, international stocks beat US companies. The one decade where US stocks beat international companies prior to 2010 was the 1990-1999 period, where the S&P 500 (just like the last 11 years) had a much higher-than-average return: +18.2% per year.
The same is true when we look at US stocks and emerging markets (index inception = 1988) over the two decades (1990-1999 and 2000-2009) prior to the 2010 stretch. Emerging markets generally tracked the results of developed international stocks, but with greater volatility. Emerging markets underperformed in the 1990s (but not by as much as developed international stocks), and then dramatically outperformed in the 2000s (much more than international developed markets).
What these charts have showed you is that the outstanding relative returns for US stocks since 2010 are not unprecedented (they look just like the 1990s), but that this outperformance is by no means a guarantee. Sometimes US stocks outperform, and sometimes they underperform. What is encouraging about the historical evidence regarding US and international stock returns is that over the long run (in this case, a decade), international stocks tend to outperform when US stocks and the S&P 500 are generating below-average or disappointing returns (1970s and 2000s), but underperform when the S&P 500 is generating above average returns. That is what you would hope for — it’s the very essence of diversification.
It’s understandable that you would want to have all your money working as hard for you as possible, and seeing the US market outperforming recently, you still feel the urge to chase the hot asset class. But what happens when you put all your eggs in one basket and that basket breaks (has really bad returns)? That is precisely what happened during the 1970-1979 and 2000-2009 periods, US stocks (the S&P 500) went 10 years with a negative return net of inflation both times. Diversifying globally, and including small cap and value asset classes in the US and international markets on the other hand, would have made a considerable difference.
From 1970 to 1979, the S&P 500 did have a positive return — +5.9% per year — but inflation was even higher, averaging an increase of +7.4% per year, resulting in a -1.5% per year real return for US stocks. Good luck retiring when your investments are going backwards for a decade! But diversifying more broadly helped out. Adding just US small cap and value stock asset classes to the S&P 500 (DFA Domestic Balanced Index) resulted in a better return: +10.1% per year. But the best result came from diversifying globally and including small cap and value stock asset classes in US and non-US markets. The DFA Global Balanced Strategy Index gained +13.4% per year, 6% annually more than inflation and 7.5% per year more than the S&P 500.
Returns overall were lower during the decade of the 2000s, but the patterns were the same. The S&P 500 actually lost -1.0% per year this time, which was 3.5% annually less than inflation, which grew at an average of 2.5% for the decade. Again, adding US small cap and value asset classes to the S&P 500 would have helped — the DFA Domestic Balanced Strategy Index gained +4.7% per year. But diversifying globally and owning small cap and value asset classes in all markets worked best; the DFA Global Balanced Strategy Index returned +7.4% per year — 4.9% annually more than inflation and 8.4% per year better than the S&P 500.
So it appears that international investing is an essential component of a long-term investment plan if you would like to avoid long droughts of dreadful returns. I know it can be a challenge to see a single asset class — US large cap stocks or more specifically US large growth/tech stocks — soar while your diversified portfolio is proceeding more slowly. I know it can be hard to make a switch to a well-diversified portfolio when other advisors are selling you on recent performance and their outstanding gains from a 25-stock US large cap portfolio. But you need to look beyond recent returns. In one sense, the above-average gains for the S&P 500 in recent years, or the even greater gains for the technology stock-dominated NASDAQ Index, are just making up for a ten-year period starting in 2000 where they lost a modest to significant amount of money.
Look at the last 20-ish years beginning in 2000. While the S&P 500 and NASDAQ Indexes have been surging in recent years, they are still way behind a globally-diversified portfolio that emphasizes small cap and value stock asset classes. Both the S&P 500 and NASDAQ Indexes have gained +6.6% per year since 2000, while the DFA Global Equity Balanced Strategy Index returned +8.9% per year — this difference in returns has led to almost double the ending wealth for the global portfolio, along with a much smoother ride.
Over time, globally diversified investors who emphasized smaller cap and lower-priced value stock asset classes in their portfolios have come out way ahead. $1 invested in the S&P 500 since 1970 has grown to $182 (+10.7% per year). In the DFA Domestic Balanced Strategy Index, that $1 became $413 (+12.5%). But in the DFA Global Balanced Strategy Index, $1 grew to a whopping $557 (+13.2% per year), almost 3x the growth in wealth compared to the S&P 500. At the same time, thanks to the diversification benefits of global investing, the DFA Global Equity Balanced Strategy Index achieved 2.5% per year higher-than-S&P 500 returns with only 2% more volatility (15.6 vs. 15.3). So ask yourself: Are you really willing to forego this potential return opportunity because of a disappointing couple of recent years?
My advice to all investors on international stocks is this: if you own them today, stick with them. If you’re thinking about getting out, don’t. You’re probably thinking about instead buying something that’s done better lately, and that’s always a recipe for disaster. If achieving your long-term goals is at all important to you, then stay the course. Finally, if you would like an assessment of your current investment plan, or would like to have a more specific conversation about your international stock allocation (Servo clients) or the best way to invest globally (other investors), feel free to email me or give me a call.
Source of data: DFA ReturnsWeb
DFA Domestic Balanced Strategy and Global Balanced Strategy Index components available upon request.
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.