I’ve been getting lots of questions about the benefits of international diversification. The questions are variations of “Why do I want to own these poorly performing investments that also create currency risk?”

Among the two most well-documented investment biases are home country (leading to dramatically overweighting one’s home country relative to global market capitalization) and recency (leading to performance chasing – buying what has outperformed at relatively high prices and selling what has underperformed at relatively low prices). Having a knowledge of history, and understanding that when it comes to all risky assets, even a decade of underperformance is likely nothing more than noise, can help overcome such biases. With that in mind, let’s go to my trusty videotape.

If you asked most investors about the long-term relative performance of U.K. and U.S. stocks, they would assume that U.S. stocks would have far outperformed. Recency bias, and the collapse of the pound sterling in the post-WWII era, would be a contributor to that belief. From 2009 through 2018, the S&P 500 Index outperformed the FTSE All-Share Index by 5.3 percentage points per annum (13.1% versus 7.8%, respectively). And the outperformance is much greater over the last five calendar years (2014-2018), with the S&P 500 outperforming by 9.7% per annum (8.5% versus -1.2%).

Now let’s take a trip back in time to a decade ago and look at the long-term performance. The FTSE data goes back to February 1955, so we will use that as our starting point. From February 1955 through December 2008, the FTSE returned 10.4% per annum, outperforming the S&P 500 Index’s return of 9.7% per annum by 0.7%age points. Even through 2013, the outperformance was still 0.7 percentage points per year (11.0 versus 10.3). That’s almost 60 years of outperformance. What conclusions would you have drawn? If we extend the data through 2018, the S&P 500’s advantage is small: 10.2% versus 10.0%. The slight underperformance occurred while the pound was falling from $2.80 to about $1.26, a drop of 55%!

Investors should not allow relatively short periods of outperformance to influence long-term investment strategies. Nor should they allow home country bias to lead to under-diversification of their portfolio. We have one more important point to cover.

Valuations and recency

The recent outperformance of U.S. stocks has led to their relative valuations (the best predictor we have of future returns) to be dramatically higher than that of the U.S. For example, as I write this on June 15, 2019, the CAPE 10 for the U.S. is about 30, while for developed European markets it’s about 19, and for developed Asia-Pacific it’s about 15.

For those interested in learning more, I recommend the February 2019 paper by Vanguard’s research team, “Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation.” The authors, Brian Scott, Kimberly Stockton and Scott J. Donaldson, began by noting that as of September 2018, U.S. stocks accounted for 55.1% of the global equity markets – almost twice the low of 29% it reached in the 1980s. Thus, regardless of residence, investors who focus solely, or mostly, on domestic stocks exclude a large portion of the global equity market.

The authors also examined the issue of currency risk. They first note: “Long term, currency has no intrinsic return – there is no yield, no coupon, no earnings growth. Therefore, long term, currency exposure affects only return volatility.” In terms of volatility, they found that in all regions, currency risk had very little impact on long-term performance, whether it was hedged or not. Sometimes hedging reduced volatility; in others it led to an increase. Hedging incurs costs (reducing returns) and increases the correlation of returns (reducing diversification benefits).

Scott, Stockton and Donaldson concluded that a good starting point for investors is weighting by global market-capitalization. As the chief research officer for Buckingham Strategic Wealth, I agree.

This commentary originally appeared July 5 on AdvisorPerspectives.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE^®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2019, The BAM ALLIANCE^®