Don't Give Up On International Stocks

As of December 22, 2016, the US Stock Market is up 13.6% year-to-date while the International Stock Market is only up 3.9%. In fact, that has been the case for the last four years, as described below:

• 2013: 16.4% vs. 15.1%
• 2014: 12.6% vs. -4.2%
• 2015: 0.4% vs. -4.3%
• 2016: 13.6% vs. 3.9%

Therefore, it is no surprise, to me, to see more and more investors, particularly new investors designing their portfolio for the first time, decreasing or even eliminating international stock holdings in their portfolios. While my crystal ball is just as cloudy as everyone else’s, this is likely to be a mistake. To understand why, let’s first take a look at the historical record.

The record for the last 20 years is probably best displayed with the Callan Periodic Table of Investment Returns. This table ranks the various major asset classes by performance for each year in a handy, color-coded table. The three boxes I’d like to concentrate on are the S&P 500 (brown, representing the US Stock Market), the MSCI EAFE (grey, representing the non-US Developed Countries Stock Market), and the MSCI Emerging Markets (orange, representing the Emerging Markets Stock Market). As you will notice, US Stocks have outperformed Developed Market Stocks in 11 of the last 20 years, including five of the last six, (six of the last seven if you include 2016). US Stocks have outperformed Emerging Market Stocks in nine of the last 20 years, including the last three years (last four if you include 2016). It is also notable that when it comes to comparing returns, Emerging Market Stocks are frequently either the best or the worst (eight out of 20 the best, and seven out of 20 the worst).

What does all that mean? It means that historically, international stocks beat US stocks about half the time and that if you wait long enough, each asset class will have its day in the sun. The problem with diversification is that it works even when you don’t want it to. However, the longer an asset class has been out of favor, the more attractive its valuations become and the better its future prospects are. That means that you can buy a larger part of a company, its profits, and its future performance for the same price. This can be most easily demonstrated by looking at the yields of mutual funds that invest in each of these types of stocks.

• US Stocks: 1.8%
• Developed Markets Stocks: 2.9%
• Emerging Markets Stocks: 2.5%

The valuation difference can also be seen using the classic measurement of the Price to Earnings Ratio:

• US Stocks: 19.7
• Developed Market Stocks: 15.7
• Emerging Markets Stocks: 13.5

That means that in order to get the same $1 of earnings from a company in the US, you would have to pay 45% more than in an emerging market and 25% more than in a developing market.

Valuations, just like past performance, are no guarantee of future performance, and there are some good reasons why international stocks, particularly in emerging market countries, often have higher yields and lower P/E ratios than US Stocks. The US is a great country and an economic powerhouse with an excellent entrepreneurial climate, strong investor protections, and a highly educated and productive workforce. As measured by Gross Domestic Product, the US still has the largest economy of any country in the world, including China with over four times as many people. The US economy is about the same size as all of Europe, despite having less than two-thirds of the population. Certainly it makes sense for an investor, particularly a US investor, to keep a large percentage of the public equity portion of his/her portfolio invested in US stocks. But increasing the percentage of the portfolio in US stocks AFTER they have performed well in the recent past, smacks of performance chasing and recency bias, which often lead to poor investing returns.

Most stock investors have an investing horizon of many decades, especially when you consider the amount of time they will be investing in retirement. The likelihood of US stocks continuing to substantially outperform international stocks continuously over that time period as they have over the last half decade seems quite low, especially when considering the benefits of diversifying the portfolio across additional dozens of national economies and additional thousands of companies. In fact, a large percentage of the difference between US stocks and international stocks can be attributed to a single factor—a strengthened dollar. In 2008, a Euro cost $1.60. Today it costs $1.04. It isn’t that international companies like Nestle, Samsung, and Toyota aren’t generating solid profits, it is that we are pricing their stocks in US dollars. That driving force, a strengthening US dollar, can be shown to swing back and forth like a pendulum over the decades. If the future resembles the past, even vaguely, it is likely that trend will reverse at some point in the next 10 to 15 years, and maybe a lot sooner.

So what is an investor to do? Just two things. First, recognize that international stocks are solid investments worthy of her investing dollars, despite the fact that many US companies receive significant revenue from other countries. Allocating a reasonable portion of a public equity portfolio to international stocks adds valuable diversification. Most experts agree that a reasonable portion is somewhere between 20% and 50% of stocks. Ignoring half of the publicly traded companies in the world when designing your portfolio is likely an error.

Second, STICK WITH YOUR PERCENTAGE. It turns out it doesn’t matter all that much in the long run whether you allocate 20% or 50% or anything in between. Each asset class will have its day in the sun. When US stocks do well, you will regret whatever percentage you have put into international stocks. When international stocks outperform, you will wish you had allocated more into that asset class. Likewise with a strengthening or weakening dollar. Changing your portfolio in response to recent performance, either good or bad, or currency changes is a recipe for investing disaster. When designing your portfolio write down each asset class you wish to invest in, assign a fixed percentage of the portfolio you will allocate to that asset class, and describe the reason why. Then, when you have doubts due to recent underperformance, you can revisit this written investing policy statement to help you to stay the course, which is the real key to investing success. Sticking with any reasonable plan is better than frequently changing from one plan to another that might seem marginally better at the time.

Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.