It seemed as if nothing could stand in the way of U.S. tech stocks. Since the spring, giants like Apple, Amazon, Facebook and Tesla climbed ever higher despite a worsening pandemic in many states and a deep recession gripping the global economy.
That changed in early September when without warning U.S. tech heavyweights hit a wall. A sharp tech sell-off dragged the wider U.S. market down with the S&P 500 falling 7% over just three trading days.
No one can say whether U.S. stocks will continue to fall in the coming weeks or recover to hit new heights. But looking back at the relative performance of world stock markets, you might be tempted to bet heavily on a U.S. market rebound.
After all, U.S. stocks have been on a tear over the last decade. The S&P 500 Index had an annualized compound return of 13.6% from 2010 to 2019. That compared to 5.3% for developed markets outside the U.S (MSCI World ex USA Index), and just 3.7% for the MSCI Emerging Markets Index.
However, you only have to look a bit further back in history to understand why it’s so important to not become transfixed by recent returns in any one market.
The last time the U.S. market surged to extraordinary heights was during the dot.com years of the late 1990s. When the bubble burst, there followed a period from 2000-2009 that’s come to be known as “the lost decade” for the U.S. stocks. In those years, the S&P 500 Index recorded one of its worst 10-year performances with an annualized compound return of minus 0.95%, according to this report from Dimensional.
By contrast, emerging markets during those years produced an annual compound return of 9.8%. So a portfolio diversification strategy that included exposure to emerging markets would have buffered your poor U.S. returns.
A closer look at historical performance of emerging markets sheds even more light on the potential benefits of diversifying your portfolio outside the U.S. and Canada.
Another report from Dimensional notes that a consistent allocation to emerging markets from 1988 to 2019 generated an annualized return of 10.7%. That beat the 5.9% from developed markets outside the U.S. and was similar to the 10.8% generated by S&P 500, including the strong returns of the last decade.
Now you would have had to put up with a lot of volatility in emerging markets during that period, much more than in developed markets, underlining the need for patience, discipline and appropriate asset allocation, the Dimensional report cautions.
However, the report also notes that emerging markets are not only a growing segment of global markets (12.5% of global capitalization at the end of 2019), but also generally “have become more open to foreign investors with fewer constraints on capital mobility.”
The composition of these markets has also evolved. While you might think of emerging markets as primarily resource based, you would be mistaken in the case of Asian economies such as China, Taiwan and South Korea where the technology sector is flourishing. Indeed, the leading sector weighting in the MSCI Emerging Market Index is information technology at 18.4%.
The benefits of geographic diversification are clear. Investing in global markets lowers your portfolio risk by exposing you to a wider set of economic and market forces than those provided by just the U.S. or Canadian markets.
By ensuring your portfolio has the right mix of assets to provide maximum diversification, you are giving yourself the best chance of reaping the returns that global markets have to offer while controlling the amount of risk you’re taking.
In part 2 of this series, I will look at the other forms of diversification and the dangers of “di-worse-ification.”