Should You Keep International Stocks in Your Portfolio?

There will always be some asset class that does poorly. Over the last few years, one of those asset classes has been international stocks. They have underperformed US stocks each of the previous three years, and it’s looking like they’ll do it again this year. Given this underperformance, we’ve had some people ask why we keep them in the portfolio.

Let’s look at this in two ways:

• The financial theory reasons
• Recent performance, and if something is different this time

We’ll start with the big picture. We design our portfolios to harvest market returns. Time and time again, we have seen that it is impossible to consistently guess what the markets will do in the future, but that folks who own the market and stay disciplined end up doing pretty well for themselves. “Own the market” means staying invested in international stocks.

As of the end of July 2016, the US represented roughly 53% of the value of the world’s stock markets.[1] So 47% of the stock market’s value was not in the US. In other words, if we were to exclude international stocks, we would be losing about half of the world market.

It’s important to remember just how interconnected the world economy is now. If you walk into any big box store, most of the stuff you see on the shelves was manufactured somewhere other than the US. You can argue about whether that is a good or bad thing, but it means that the world is tightly tied together. Global shipping routes give us a clear picture of that.

B.S. Halpern (T. Hengl; D. Groll) / Wikimedia Commons / CC BY-SA 3.0

The world economy is no longer in neat little boxes where you can safely ignore what is happening on the other side of  the globe. I think of it a little bit like industries. The manufacturing industry in the US looks very different from the technology industry or the financial services industry, but I want them all in my portfolio so I can capture market returns. The only way to do this is to own everything.

Just from a pure diversification stand point, we don’t want to exclude international stocks. We want to own as many securities as possible in order to eliminate the risks the market doesn’t compensate us for.

International stocks are actually excellent diversifiers. If we look at the historical data, US and international stocks move pretty differently from each other. The correlation (a statistical measure of how similar the movement of two series are) between the S&P 500 Index (US stocks) and the MSCI EAFE Index (international developed stocks) from January 1970 to July 2016 was only 0.633.

To put that in perspective, over the same time period, the correlation between the S&P 500 Index and the CRSP 9-10 Index (which represents the microcap portion of the US market) was 0.754. In other words, they are still stocks, but the US and International markets move reasonably differently through time (and we’re certainly seeing that now).

But there’s an important point to make here. Just because they move differently, there is no difference in expected returns. There’s no difference in the level of risk of a company based on whether they are headquartered in New York, London, or Tokyo. And we can see that in the data as well.

Data from January 1970 to July 2016. Data courtesy of Dimensional Fund Advisors.

Now, at first glance, this doesn’t look so good for my contention that there is no expected return difference between US and international stocks. But the key thing to notice here is the standard deviations—they’re pretty massive numbers, which means these things are all over the place. So much so that there is no reliable statistical difference between the returns.

There’s a very good chance that the difference is purely random noise. We have over forty-five years of data, and we can’t reliably say that either the US or international stocks tend to outperform the other.

We can also see this if we simply look at how often international stocks outperform US stocks, and vice versa.

Data used longest available period. Monthly data from 1/70-7/16. Quarterly data from 1/70-6/16. Annual Data from 1/70-12/15. Data courtesy of Dimensional Fund Advisors.

They’re pretty evenly split. If we were to select a random month, quarter, or year, it’s just as likely that international stocks did better in that period than US stocks.

How they did during the last period doesn’t tell us anything either. One of the ways we can see if a security’s previous returns tell us anything about future returns is a statistical measure called autocorrelation. This is like a lot like the normal correlations we used earlier, except now we’re looking at the correlation of a security with its past self.

For instance, with our annual numbers, we would be running a correlation between the returns of the MSCI EAFE Index from 1970 to 2014 with the returns of the MSCI EAFE Index from 1971 to 2015. If there’s no significant correlation here, it’s unlikely that previous returns give us any guidance about what future returns will be.

Quarterly Autocorrelation data from 4/70-6/16. Annual Autocorrelation data from 1/71-12/15. Data courtesy of Dimensional Fund Advisors.

As you can see, there isn’t much here. The differences we’re seeing from 0 are simply statistical noise. What either the S&P 500 Index or the MSCI EAFE Index did last time doesn’t tell us anything meaningful about what it will do this time around.

It’s a coin flip whether US stocks will beat international stocks or international stocks will beat US stocks.

Let’s think about coin flips for a second. You’re equally likely to get heads or tails, and each flip is independent. If you got heads last time, that doesn’t mean anything for the next flip—you still have a 50% chance of getting either heads or tails.

Let’s say we filled all 68,576 seat of Gillette Stadium with folks flipping coins (we couldn’t afford to rent out Michigan Stadium with its 107,601 seats). And let’s say that we’re trying to find the best coin flipper. We’re going to have everyone flip their coins, and anyone who gets tails loses. It would take about 16 coin flips for us to expect to get a winner.

Now, that last person left is not actually the best coin flipper. They just got incredibly lucky. And it’s the same story with the returns of US and International stocks. Since which will do better is random, we expect to see a whole bunch of streaks—and big streaks every once in a while.

Looking at the historical data, we see those streaks pretty clearly. Using annual returns from 1970 on (which was the start of the MSCI EAFE Index), there are some pretty big streaks. The longest that the US has outperformed international stocks in a row is four years, which has happened twice—from 1989-1992 and 1995-1998.

On the other hand, we’ve had two periods where international stocks have outperformed US stocks six years in a row—1983-1988 and 2002-2007. It’s interesting to note that these four streaks represent almost half of the total time period (twenty of the forty-six years we have data for).

Right now, we’re already three years into our current streak of US outperformance, and it’s looking like we may be adding a fourth. But, as we can see, these streaks happen. The fact that international stocks have underperformed US stocks for a while is nothing new and it doesn’t mean anything is different this time. It just means that international stocks have flipped tails three times in a row so far.

What matters now is what happens going forward. We don’t know if this streak will continue, if it will end this year (if it ends this year, hopefully it will be because international stocks go up, not US stocks going down). There is simply no way of predicting.

So we come back to where we started—wanting to harvest long-term market returns. And the way to do that is to stay diversified and disciplined. We wouldn’t drop energy stocks from our portfolio if they have a bad couple of years, so we don’t want to drop international stocks from our portfolio after a bad couple of years either.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

[1] Data courtesy of Dimensional Fund Advisors.