International stocks have trailed U. S stocks for more than 100 years performance aside the U. S market is well Diversified across Industries makes it more than 50 percent of the global stock market and lots of U.
S companies have International Revenue exposure additionally International diversification has gotten less effective over time as correlations across markets have increased these Arguments for foregoing International diversification in favor of U. S stocks do seem compelling at the surface but as I will explain they are flimsy at best International diversification is critical both theoretically and empirically to sensible portfolio Construction I'm Ben Felix portfolio manager at pwl Capital and I'm going to tell you why International diversification is a free lunch a quick note before I start I'm in Canada my observation is that both Canadian and U. S based investors often have U.
S Centric investment portfolios in this video I'm referring to stocks outside of the U. S as International in 1952 Harry Markowitz published portfolio selection one of the most important papers to Modern Financial economics Theory Markowitz showed that the risk of an Investment Portfolio is not defined by the average riskiness of its underlying assets but by the extent to which they move together their correlations diversifying a portfolio across imperfectly correlated assets allows investors to increase their expected returns without increasing their risk or decrease their risk without reducing their expected returns Markowitz argued that diversification is the only free lunch in investing because increasing expected returns typically requires taking more risk in 1964 Bill Sharp developed the capital asset pricing model or the cap M which is an equilibrium model that it aims to unite asset pricing Theory with Markowitz portfolio Theory the cap M suggests that investors optimize their portfolios for return and risk by diversifying as Markowitz theory predicts all assets in an efficient market are priced such that the market portfolio is the mean variance optimal portfolio from this theoretical perspective excluding International stocks from a portfolio is sub-optimal the problem for many investors is that by nature of being Diversified you always hold both the best and worst performing countries it's tempting to look at the top performers like the U. S market and imagine how much wealthier you would be if you had only invested in them unfortunately it's not possible to predict which markets will be the best feature performers based on historical data and in some cases historical data can lead you in the wrong direction this kind of thinking leads to the well-documented performance chasing behavior of retail investors which ultimately makes them worse off in a 2021 article titled the long run is lying to you Cliff asness showed that from 1980 through 2020 nearly all of the outperformance of the S P 500 which closely tracks the U.
S stock market compared to the efe index which represents 21 developed markets excluding the US and Canada is explained by U. S stock prices getting more expensive relative to their cyclically adjusted earnings over this period U. S Stocks outperformed by about two percent per year but adjusting for their valuation changes the outperformance was only about 0.
4 percent per year adjusting for valuation changes is important because current valuations are one of the most informative metrics that we have for estimating expected returns when stock prices are higher expected returns are lower this is still a noisy relationship to be clear it's not gravity but it's the best we have the U. S stock market's performance dominance extends further back than 1980. it has beaten the world excluding U.
S stock markets by about two percent per year on average for more than 100 years the 2022 paper is the United States a lucky Survivor a hierarchical Bayesian approach finds that realized U. S Equity returns have exceeded their own expected returns by about two percent per year and that this observation is equally explained by luck where U. S companies ended up doing better than expected due to disasters that did not materialize and a learning where investors have deemed U.
S stocks safer over time driving up their valuations conditioning future expectations for U. S stock Returns on performance that can be described as past luck and Rising valuations is likely to be an error we have to consider whether there will be enough luck and learning related valuation increases to propel U. S stocks ahead of the rest of the world for our relevant investment lifetimes keeping in mind that the currently High U.
S valuations are an additional hurdle to overcome this is likely related to the literature on the non-existent or negative relationship between economic growth and stock returns expected future economic growth is already in today's prices you can't earn a riskless profit by investing in the most economically robust countries investors in most countries the U. S being one of the few exceptions have benefited in terms of risk-adjusted returns from International diversification hoping to be a future outlier is rarely a good strategy well these long-term data make international diversification look good it is interesting to consider whether the benefits have declined over time as markets have become increasingly connected to each other while short-term returns have certainly become increasingly correlated there is more to the story for long-term investors the 2018 paper Global portfolio diversification for long Horizon investors explains that an increase in cash flow shock correlations make a globally Diversified portfolio riskier for investors at all Horizons but an increase in the correlation of discount rate shocks does not reduce the benefits of global diversification for long-term investors the authors find empirically that correlations of discount rate shocks resulting from Financial globalization appear to be the main driver of increasing correlations implying that the benefits of global Equity diversification have not declined for long Horizon investors this is an important point that often gets missed short-term correlations can increase while long Horizon investors still benefit from International diversification a similar point is made in the 2011 paper International diversification Works eventually the authors argue that in the short-term Global diversification can disappoint because markets tend to crash at the same time but long-term returns are far more important to wealth creation and wealth destruction and over the long term markets do not tend to crash at the same time International diversification protects investors against holding concentrated positions in countries that end up with poor long-term returns as a reminder we cannot know ahead of time which countries those will be in the 2022 paper long Horizon losses in stocks bonds and bills evidence from a broad sample of developed markets the authors use a bootstrap methodology drawing on the experience of 38 developed markets from 1890 to 2019 to demonstrate that a representative investor had a 13 chance of losing purchasing power in domestic stocks at the 30-year Horizon and a much lower four percent chance in international stocks we need to take a quick step back and look at some more data for most of this video I've been speaking as if U. S stock returns have been unconditionally Superior to International returns since 1900 while true over the full period there have been sub-periods where U.
S stocks trailed inter National stocks for extended periods of time from 1950 through 1989 real USD returns of U. S stocks trailed real USD returns of world X U. S Stocks by 2.
65 percent per year within that period from 1968 through 1982 U. S stocks returned a real negative 0. 08 percent per year while International stocks returned 3.
61 per year more recently in the so-called lost decade from 2000 through 2009 U. S stocks lost 2. 25 per year in real terms while International stocks returned a positive 1.
01 per year looking at 10-year rolling periods with a one-year step from 1900 through 2022 U. S stocks have only beaten Global X U. S stocks 59 of the time I'm not arguing that International stocks are superior to U.
S stocks but it is clear that over longer periods when U. S stocks have tanked International stocks have held their own looking past market index returns another important observation is that while cross-country correlations have been increasing over time this has been more so the case with large cap growth stocks than with small cap value stocks in the 2009 paper International stock return co-movements the authors find that large growth stocks are more correlated across countries than small value stocks and that the difference in correlation has increased over time this finding and other related research suggests that International value and small cap value stocks may offer portfolio improvements above and beyond those offered by International Market indexes even if we agree at this point that International diversification is important a common argument is that it can be achieved by owning domestic stocks that generate their revenues internationally well this argument does seem plausible it does not hold up empirically the stocks of multinational firms typically move closely with their respective National Market indexes making them poor tools for diversification in the relatively rare cases where the addition of multinationals to a domestic Equity index empirically improves portfolio efficiency adding International equities to the same domestic index provides even more substantial improvements additionally diversification across countries within an industry is empirically more effective for risk reduction than industry diversification within a country country diversification matters and cannot be fully replicated using domestic firms with International revenues International diversification is both theoretically and empirically important to portfolio construction it is easy for investors to get lulled into a sense of security or superiority by the past success of a single Market but past success and high future expectations are reflected in current prices making it less likely that future returns will reflect the past since we cannot know which markets will be most successful in terms of investment returns in the future broad Global diversification across countries is the most sensible approach for most investors thanks for watching I'm Ben Felix portfolio manager at pwl Capital if you enjoyed this video please share it with someone who only owns U.
