Investors are running out of patience with international stocks. I even hear rumblings from Servo clients, who have always bought into the idea of broad global diversification.
From a US perspective, it’s been a long time since diversifying into non-US markets has paid off. If we close the year where we are today, 2022 will mark the 11th time in the last 13 years that the S&P 500 Index has outperformed the MSCI All Country World ex-USA Index. Wow. Even for highly disciplined investors, almost a decade and a half of continual underperformance for non-US stocks is starting to feel like venturing outside the US market is just throwing good money after bad.
So let’s revisit a common question on most investors’ minds today: Is it time to abandon international stocks?
To start, I want to provide some big-picture perspectives on global markets and the role the US plays in the world. After years of superior returns compared to many other countries, the US market is by far the largest stock market in the world; 60% of the world’s wealth in publicly traded stocks resides in the US. But this also means that countries outside the US represent 40% of the world’s wealth. If we decide to invest only in the US market, we’re ignoring a lot of the available investment opportunities.
Next, let’s look back in history to see if there were other examples when a specific country had stock market returns that far outstripped the rest of the world. If the US is on a run unlike anything we’ve seen before, maybe “this time is different.”
Does anyone remember Japan?
The run for Japanese stocks from 1971 through 1988 dwarfs the outperformance for US stocks relative to the rest of the world in the 1990s or since 2010. Japanese stock returns in the 70s and 80s were nothing short of incredible. Take a look.
The MSCI Japan Index returned over 26% per year for almost two decades. What about the World excluding Japanese stocks? Not bad—a gain of +11.4% per year. US stocks, as represented by the S&P 500, were actually one of the lower returning markets over this period with just a +11% per year return. But annual returns hide the real story, which is that $1 in Japan in 1971 grew to almost $69 by 1988 compared to just $7 in the rest of the world and $6.50 in the US! That’s an extraordinary difference in wealth accumulation between different countries. Imagine missing out on the big winner by concentrating in the wrong country.
But 1971-1988 is just half the story. What happened to Japanese stocks once they finally hit their zenith after years of outperforming the rest of the world? It has not been good. The Japanese stock market has had virtually no return for an entire generation.
Since 1989, the S&P 500 has earned +10.5% per year—similar to its return from 1971 to 1988, and the World Stock Index excluding Japanese stocks wasn’t far behind, with almost a +9.5% per year return. Japan, on the other hand, gained just 0.6% per year. That return badly trails risk-free Treasury Bills, inflation, you name it. You couldn’t have gotten a lower long-term investment return if you tried. Even the always disappointing gold and commodities indexes managed to do better.
I am not predicting that the US will follow in Japan’s footsteps. Instead, I use this example to show you that single country stock markets—especially after above-average returns for an extended period relative to the rest of the world—can and do go long periods with dismal results. If you shift your portfolio more in the direction of a high-flying country at close to the peak of its run, only to experience a disproportionate percentage of the potential ensuing underperformance, your investment portfolio is really going to suffer, and your financial plan will more than likely be compromised.
But let’s return to this idea that the US is not Japan, or said differently, that the US could not go an extended period with disappointing returns relative to the rest of the world. That viewpoint is a classic case of recency bias—we’ve seen almost nothing but good returns for US stocks since 2010, so we assume that trend will continue indefinitely. Recency bias is one of the most significant behavioral errors most investors (and many advisors) tend to make.
The antidote to recency bias is to adopt a longer perspective—as Winston Churchill said: “The farther back you look, the further ahead you can see.” Fortunately, we don’t have to look back very far to find a period where US stocks were terrible.
I have in mind the 2000-2009 period, the ten years immediately preceding the most recent US stock market run. US stock returns for the first decade of this century were so bad it was called “The Lost Decade.” Why? US stocks lost money cumulatively for the entire period. Look at the chart below.
The S&P 500 Index of large US stocks lost 1% per year. Ouch. International stocks—the same ones that have underwhelmed for so long recently—actually gained +3% per year and almost 36% cumulatively.
I like this period for a few reasons. First, it shows that international stocks can and do go long periods where they outperform the US market, and missing out on these periods of outperformance can significantly lower your returns. Second, the timing of this period is similar to today; US stocks outperformed non-US stocks during most of the 1990s (after underperforming dramatically in the 80s), and investors at that time had an urge to bet big on US-only portfolios, just like today. Will history repeat once again? I wouldn’t bet against it.
But most importantly, it shows that simply by holding a globally diversified portfolio of US and non-US stocks—represented by the all-stock Dimensional Core Plus Wealth Model Index—you don’t have to guess which country or region is going to outperform next to have a good investment experience. Over this decade-long stretch, the Core Plus Wealth Index returned over 5% per year, and $1 invested grew to almost $1.70. And this was a stretch that saw two of the worst four bear markets in 90 years, along with terrible large cap US stock returns.
Why did a globally diversified portfolio such as the Dimensional Core Plus Wealth Index work so well, outperforming the traditional S&P and MSCI indexes? Because of what it owns. The Dimensional Core Plus Wealth Index doesn’t just hold the biggest and most expensive stocks in markets. Instead, it has increased exposure to stocks with higher expected returns: smaller companies, lower-priced value companies, and higher profitability companies. Simply put, it’s more diversified.
These different types of stocks have an opportunity to perform well when traditional large growth stocks that dominate index funds have disappointing returns. Diversifying globally when investing this way is crucial because it makes it possible to target more of these higher expected-returning companies in more regions of the world—increasing the likelihood we’ll see the higher returns we’d expect.
Let’s look at the components of the Dimensional Core Plus Wealth Index Index and the traditional US and non-US indexes from 2000-2009 to see where the opportunities materialized.
The S&P 500 Index had the absolute lowest returns of all core stock indexes during this stretch. The international index of large stocks (MSCI All Country World ex USA Index) wasn’t far behind, beating only US and international high profitability stocks. But the main takeaway from the chart above is that as you go from the bottom to the top of the index list of increasing returns, international stock indexes were ahead of US stock indexes in every case.
These results will come as a surprise to many; the areas of the market you’re most apprehensive about owning and buying more of today had the best returns in the previous period! Emerging Markets, especially value, and international value stocks (Dimensional International Vector Index), were some of the clear leaders that pushed the Dimensional Core Plus Wealth Index to reasonable returns during this incredibly difficult stretch.
Notice where the relatively high returns on US stocks have come from since 2010--their exceptionally low returns during the previous decade! If your goal is to earn sufficiently high long-term returns to achieve your goals, and if history is any guide, where should you be looking today for those future returns? Should you be looking to the thing or things that have done the best in recent years or the worst? Of course, you want to own, and even buy more of, the things that have struggled recently.
Of course, Europe is a mess. Companies overseas aren’t as profitable today as US stocks are, nor are their prices and price to earnings ratios nearly as high. Owning non-US stocks, especially smaller, cheaper, and more profitable companies gives you an incredible opportunity to own great businesses at really depressed prices. Great values, we know, are where good long-term returns often come from.
Back to the question of abandoning international stocks, I think it’s a terrible idea. If you’ve held 30% or 40% in non-US stocks for the last five or ten years, stick to that mix. The case for non-US stocks eventually returning to favor and outperforming the US is strong. No company, no sector, no asset class, and no country or region is always the best performer, nor do trends ever persist forever in investing. Remember than international diversification "worked" in the 2000s when US stocks struggled. Since 2010 the S&P 500 has averaged over 12.5% per year, 25% more annually than it's the 90-year average. Did you really need international to do even better?
Try to take a step back from performance handicapping and remember the core principles we follow that are designed to help you achieve a better investment experience:
My advice: Stay diversified, stay disciplined, and accept the returns that broad market portfolios of stocks and bonds offer. Even if your results trail the hot sector or country in years to come, the outcome should still be more than sufficient to achieve your reasonable financial goals based on long-term rates of historical return.
And isn’t this why we’re really investing?
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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.