US Stocks, Foreign Stocks—or Both?

• The outperformance of US equities in recent years has made many investors skeptical of foreign securities.
• As with other asset classes, US and foreign stocks often move in different cycles that can begin and end unpredictably.
• Both common sense and research dictate that investors should hedge bets and hold a global portfolio.

My colleague Andrew Tanzer, who pens our Global Equation  blog, recently wrote that globalization, in terms of trade flows and economic integration, is coming under stress — see his blog post entitled “ Globalization: Past, Present, and Future “. But when I look at the financial system, I see interconnected markets tied together by technology and the virtually instantaneous flow of information. If Fed Chairwoman Janet Yellen makes unanticipated comments about interest rate policy, within seconds not only will stocks react around the globe, but so will bonds, currencies, and commodity prices. The same applies if China unexpectedly devalues its currency or reports economic growth well above or below forecasts. In this article, I’d like to provide some thoughts on global investing.

The Recent Past

These days I do hear many investors questioning the validity of global investing. But this has less to do with rising political opposition to globalization at home and abroad than to the recent wide gap in market performance. For instance, from January 2007 to April 2016, the S&P 500 Index returned 78% while foreign stocks (MSCI World ex USA Index) returned only 7%. That is a stark divergence.

But investors who now fear foreign stocks but feel safe and sound in US ones are committing what in behavioral finance is called recency bias , which is the tendency to extrapolate what occurred yesterday to tomorrow and far into the future. By the same token, many investors extrapolate the recent strength of the US dollar—an important factor in the recent robust performance of US stocks relative to foreign markets—into the future. In fact, our research shows that currency movements are highly cyclical and that the dollar has actually depreciated by more than 30% against a basket of currencies since 1976.

Not surprisingly, following this long period of relatively strong US stock performance, the US market looks more expensive (on a relative basis) when compared to foreign markets (see Exhibit 1). How much more expensive on its own historical average valuation (US looks close to its average – how far away from the mean? Is this well within one standard deviation? If so, I would just say more expensive to foreign markets).

Just as with currencies—and value stocks vs. growth, small caps vs. large caps—international and domestic stocks often move in somewhat different cycles. Exhibit 2 illustrates the point. During a nearly 6-year period commencing in January 2002, foreign stocks trounced US stocks by more than 11 percentage points annualized. Then, just as so many American investors were saying, “Get me out of the US market; I only want to be in foreign markets,” the cycle turned (it never announces itself), and foreign stocks lagged badly for eight years.

At some point the cycle will likely turn again, but since we cannot divine when these cycles will start or conclude, we believe that investors are best off holding a diversified global portfolio. To me, this is common sense: How is it possible that investing in a one-country portfolio with 500 stocks (the US market) is safer than holding a 45-country, global portfolio comprised of 10,000 companies? Empirical data also back up the intuitive argument.

The Global Portfolio

Let’s say you have three options: you can invest in US stocks only, non-US stocks only, or you can hedge your bets and invest in some of both (say, 75% US, 25% foreign stocks). We went back to January 1970 and studied 435 10-year rolling periods to March 2016, rolling portfolios forward a month at a time. Conclusion: the diversified global portfolio generated the best return among the three portfolios only 6% of the time, but it never suffered the worst return (see Exhibit 3). US stocks over this 46-year period returned 10.2% annualized with less risk (as measured by standard deviation, or volatility) than foreign stocks (which returned 9.4%), but, due to the portfolio benefits of diversification, the global portfolio returned the same 10.2% as the US portfolio but with the lowest risk of the three portfolios. Thus, in finance parlance the diversified global portfolio generated the highest Sharpe Ratio, or best risk-adjusted return.

I have just described what I think is a compelling fundamental case for investing in both US and foreign securities rather than holding a US- or foreign-only portfolio. Of course, there are multiple strategies and styles for incorporating international stocks into a portfolio. That topic is beyond the scope of this article, but I do want to mention one such strategy that we have researched recently and already implement in our own international large-company growth stock portfolio. This is to tilt country portfolio allocations away from the largest countries in the international-developed market index (such as Japan and the UK) and toward smaller countries. We have shown through our research and live data that this redistribution of country weightings enhances risk-adjusted returns in an international portfolio. I invite you to read more about our research on this topic by viewing our blog post, “ Does the Size Premium Apply to Countries? “.