What happens if you only invest in the U.S. stock market and it goes no where over a longer period of time, say a lost decade? Your stock allocation, built to grow your money, just failed. Something needs to pick up the slack. And there’s no guarantee your bond allocation will come through.
Enter international stocks.
At first sight, it may not seem like it matters when you compare the long term returns of U.S. stocks (S&P 500), international stocks (MSCI EAFE), and a 50/50 split since 1970. As the table below shows, having a portion of your stock allocation diversified internationally doesn’t improve your returns, but you don’t really lose much either.
| Long Term Performance | |||
| US Stocks | International Stocks | 50/50 Split | |
| Annual | 10.47% | 9.68% | 10.36% |
| Median | 15.06% | 11.63% | 15.09% |
*This doesn’t include emerging markets.
Then there’s the big knock against international diversification – that U.S. stocks are too correlated with international stocks when diversification is needed most. I have no argument with that, as the table below shows.
| How Often U.S. and International Stocks Move Together | ||||
| Both Rise | Only US Stocks Rise | Only Int’l Stocks Rise | Both Fall | |
| # of Years | 31 | 5 | 1 | 8 |
| % of Years | 69% | 11% | 2% | 18% |
It’s fairly obvious that U.S. and international stocks are very correlated. They move in the same direction most of the time – 39 of the last 45 years.
If volatility is your biggest concern, a global diversification won’t protect you from short term market falls. We saw this in 2000 to 2002 and again in 2008. Owning both US and international stocks offered little protection from either crash. Because of this, many investors questioned the reasoning behind diversifying beyond their borders.
What gets overlooked is, a global allocation is not meant to protect you from short term volatility or market crashes. That is what bonds are for. The point of international diversification is to avoid long term poor performance from a single market.
While U.S. and international stocks move in the same direction most of the time, the yearly returns are not the same. Comparing the difference in annual returns between the two shows why diversification matters.
| Amount of Outperformance Broken Down by # of Years | |||
| US Stocks | International Stocks | Total (%) | |
| Less than 5% | 2 | 6 | 8 (18%) |
| Less than 10% | 8 | 13 | 21 (47%) |
| More than 10% | 13 | 11 | 24 (53%) |
| More than 20% | 6 | 5 | 11 (24%) |
A little over half the time (24 of 45 years) one outperformed the other by at least 10%. Put another way, at least half the time, one market underperformed the other by at least 10%.
Some of these are great returns beaten out by a better one. Some are low returns or losses being beaten. A random low return or loss will hurt, but it won’t destroy your chance to grow money. The risk is being hit with a string of low returns and/or losses, which has happened before – the U.S. stock market saw several 5 and 10 year periods, and one of 15 years, with little to no returns – and will likely happen again at some point.
This happens because markets go through cycles of great returns followed by poor returns. Sometimes those periods of poor returns last longer than expected.
Now, what happens if you start investing in U.S. stocks at the beginning of a period of poor returns? What if it lasts longer than you expect? What if your stock allocation, of only U.S. stocks, barely beats inflation or worse doesn’t beat inflation over the next decade?
There is always a risk that your stock allocation doesn’t cooperate, right when you need your money to grow. That risk grows if you rely on an overly concentrated stock allocation that has little to no return over a longer time period. Owning stocks from countries other than your own, lowers that risk over time.
