To say international stocks haven’t been doing great relative to US stocks is a massive understatement. What does that mean for your portfolio?
Most of the investment advice you get is (or should be) conditional. Advisors tend to steer clear of definitive, blanket statements, but this is one that I’m pretty comfortable making if you have stocks in your portfolio, you should probably own both domestic and international stocks.
Diversification is a good thing. It’s pretty much the only free lunch in finance. And diversification doesn’t stop at the water’s edge. World markets are so tightly intertwined now that only investing in the US would be similar to saying that you’ll only invest in healthcare stocks. You may get lucky and outperform every once in a while, but you’re leaving a huge amount on the table.
It’s easy to just think about the US markets. After all, it’s where we live, and the financial media focuses the majority of their attention here. But the US only represents about half of the value of world stock markets, so about half of the value of world stock markets is outside the states.
We can’t just throw these stocks away – they’re important for harvesting market returns. Throwing out half of the market would be a huge blow to your diversification.
It’s A Coin Flip
It’s not like the US (or the international) market alone is a better investment. There is no expected return difference between a company based in New York and one based in Tokyo. If we look at the historical data, US and international stocks are pretty well tied in terms of how often they outperform each other:
| Monthly | Quarterly | Annual | |
| US Stocks Win | 49.9% | 52.7% | 50% |
| International Stocks Win | 50.1% | 47.3% | 50% |
US stocks represented by the S&P 500 Index. International stocks represented by the MSCI EAFE Index. For illustration purposes only. Indices are not available for direct investment. 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.
It’s hard to get closer to a coin flip than this. In any random period, either segment is equally likely to win. And just like someone sitting there flipping an actual coin, we’ll see streaks every once in a while. In fact, it would be weird if we didn’t see streaks.
Using the MSCI EAFE Index as our proxy for international stocks, and the S&P 500 Index as our proxy for US stocks, we can see that streaks are normal. Focusing on annual returns from 1970 (when the MSCI EAFE Index started) to 2015, the longest US-leading streak is four years in a row, and that has only happened twice (1989-1992 and 1995-1998). International stocks have twice topped US stocks for six years in a row (1983-1988 and 2002-2007). Of the forty-six years in the period, these extreme streaks accounted for twenty.
Past Performance Is Not Indicative of Future Returns
Right now, we’re sitting at three years of US outperformance, and unless international stocks pick up significantly, we’ll probably be adding to that list of four-year streaks. But that doesn’t tell us anything about what will happen next year (or the rest of this year).
There’s a statistical measure called “autocorrelation” that lets us see how much previous numbers in a series tell us about the future numbers. The autocorrelation for both the MSCI EAFE Index and S&P 500 over the same period is pretty close to zero. The previous returns of the two indices don’t tell us anything meaningful about future movements.
We don’t really care what the markets have done in the past. Those returns have already happened, and we’re never going to get them back. We care about the future.
The past can serve as a rough guide, but we always need to come back to the basics – risk. If something has higher returns, it has to have higher risk – otherwise market participants would bid up the price and drive down the returns to the appropriate level.
Do stocks in the US have higher levels of risk than international stocks? The data shows us the answer to that is no. There is no significant difference between the returns of the S&P 500 Index and the MSCI EAFE Index.
What You Should Do
So where does this leave you? You want to stick with market weights in your portfolio wherever possible. But your situation might have some unique considerations.
If you live in the US, you’re spending money in the US and a huge chunk of the stuff you consume is still produced in the US. So having a slight tilt toward US stocks might make sense. Especially considering that investing in international stocks tends to be slightly more expensive. But remember, you need the benefits of diversification.
However much international exposure you want in your portfolio, the important thing is to stick to it. Trying to guess where the market is going is the quickest way to sabotage your retirement.
