Bob French, CFA

A World of Opportunities: The Benefits of Global Diversification

If the beginning of 2016 has you re-evaluating your asset allocation, you’re not alone. While we’re not looking at big losses anymore, it’s been a bumpy ride.

A quick glance at the global market, though, hasn’t offered any relief. China keeps devaluing its currency, and the economies of Russia and Brazil are slumping. U.S. stocks have outperformed foreign stocks in the last few years. Some investors are wondering if they really need to invest outside the U.S.

If you only look at the short-term numbers, it’s easy to see why. The US market has significantly outperformed the rest of the world. If we look at the returns since the beginning of the decade – from January 2010, until February 2016 – the S&P 500 Index had an annualized return of 11.66%. Compare this to the MSCI World ex USA Index, which had an annualized return of 2.26%, as well as the MSCI Emerging Markets Index’s annualized return of -2.28%.

It’s obvious why a U.S.‑based investor may think it’s better to stay away from international investing, but you don’t get the full story by just looking at the short-term returns of different asset classes in isolation. You need to take a long-term perspective and think about how everything affects your total portfolio.

Consider these two facts:

  1. International stocks provide valuable diversification benefits.
  2. Recent performance is not an indicator of future returns.

Three Reasons You Should Consider Global Diversification

Think about what you’re missing. Look at equity markets. The global equity market represents a world of investment opportunities (pun intended). Just about half of the global stock market is outside the US. (See Exhibit 1.)

The Benefits of Global Diversification - Exhibit 1

Non-U.S. stocks account for 48% of the world market cap. They represent more than 10,000 companies in 40-plus countries. A U.S.-only portfolio wouldn’t be exposed to the performance of those markets.

Think about what you’re not missing. When you invest, you can’t expect a return without taking on risk. That means dips in your portfolio are unavoidable.

No other example stands out starker than the Lost Decade. From 2000 to 2009, the S&P 500 Index recorded its worst 10-year performance ever with a total cumulative return of -9.1%.

Looking beyond U.S. large-cap securities, conditions were more favorable for global equity investors. Most equity asset classes outside the U.S. had positive returns over the course of the decade. (See Exhibit 2.)

The Benefits of Global Diversification - Exhibit 2

By investing in a globally diversified portfolio, the Lost Decade wasn’t quite so lost.

Consider an even bigger picture. Rather than look at recent performance, consider performance in the past eleven decades (there’s that long-term perspective). Of the past eleven decades, the U.S. market outperformed the world market in five, and the world market beat it six times. In other words, it’s a toss-up whether the US or the world market will do better.

Are You Invested in the Right Countries?

Here’s the truth: there’s no such thing as being invested in the right countries. It’s impossible to choose which country will outperform another. In Exhibit 3 you can see just how random country equity market rankings are. There is no pattern or formula you can use to predict which will be the best or worst country in any given year.

benefits of global diversification

If you only invest in a single country (we’re talking about American investors, but investors overweight their home country pretty much universally), you’re exposing yourself to a lot of extra volatility that you don’t need to take. Since 1996, for example, the average return of the best-performing developed market country was 37.5%. The average return of the worst-performing country was -15.7%. In the last twenty years, the U.S. has been the best-performing country twice and the worst-performing once. By spreading your money throughout the world markets, you can smooth out these bumps.

Don’t Make the Mistake of Shooting for the High Score

By diversifying, you might not have the best-performing portfolio, but you also won’t have the worst. Investing isn’t about putting up huge returns – it’s a tool for meeting your financial goals. You don’t want to take any more risk than you actually need to, and you need to focus on the long term.

Global diversification can help you meet your goals. If you invest globally, you’re poised to capture the market returns of the total market, not just a small sliver of the market.

Next, read Why Investing During Retirement is Different.

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