After a rebound in the early summer, August was another discouraging month in the stock market. During this latest pullback, I’ve fielded a number of questions from clients about the wisdom of international diversification, given the continuing underperformance of European and emerging markets.
The clients wanted to know if it would be better to concentrate the equity portion of their portfolio in U.S. stocks where returns have been better not only this year but going back many years.
Before we look at the answer to this question, let’s review some of the numbers. PWL’s August market statistics report shows it’s been a pretty dismal year for stocks around the world, thanks to high inflation, rising interest rates and slowing economies.
Global diversification has brought no relief from falling stocks in Canada and the U.S. Large and mid-cap developed international stocks were down 16.6% (in Canadian dollars) to the end of August while emerging markets were down 14.2%.
That underperformance reflects the many challenges faced by countries outside North America. In Europe, the war in Ukraine has led to surging energy prices that have compounded an already serious inflation problem. Many economists now predict a recession in the European Union and Britain.
Elsewhere, emerging markets indexes have suffered mainly because of problems in China, where the economy has slowed sharply amid tough anti-COVID shutdowns and a debt crisis in the real estate sector.
While those are serious short-term issues, underperformance in international markets is nothing new. North American markets have produced better returns for many years, vastly so in the case of the U.S. For example, the U.S. stock market (in Canadian dollars) returned 16.0% a year over the 10 years to August 31, compared to 8.4% for developed international stocks and 5.8% for emerging markets.
So, given this experience, why not retreat from a globally diversified stock portfolio?
The first reason is that you would be giving into recency bias. Yes, returns from U.S. stocks have been especially strong over the last decade. However, this doesn’t mean their good run will continue indefinitely or that we should put all our eggs in this basket.
You only have to look back to the 2000s to find a different picture. The years following the collapse of the dot.com bubble from 2000-to-2009 are known as the “lost decade” for U.S. stocks. Back then, the S&P 500 Index recorded one of its worst 10-year performances with a total cumulative return of –9.1%, according to this report from Dimensional Fund Advisors.
It’s interesting to take an even longer-term perspective on global markets. This year’s Credit Suisse Global Investment Returns Yearbook focuses on diversification as a special topic. It’s a treasure trove of facts drawn from 122 years of market data drawn from markets around the world.
Among the observations its authors make is that over the last 50 years, investing in stocks globally has generated higher reward/risk ratios than investing only domestically in most countries.
The U.S. was an important exception. The authors, financial historians Elroy Dimson, Paul Marsh and Mike Staunton, found that in hindsight U.S. investors would have been better off sticking to their home market due to its strong historic returns and low volatility.
However, the authors are also quick to emphasize that “good investment decisions based on sensible criteria, can sometimes have disappointing outcomes.” Hindsight may be 20/20 but our vision into the future is foggy.
“Ex ante, it is hard to predict which countries will perform best or where domestic investment might beat global. There is no obvious reason to expect continued American exceptionalism,” the authors write. “Prospectively, our advice to investors from all countries, including the U.S.A., is that they should invest globally. This is very likely to reduce risk and increase the Sharpe ratio (risk-adjusted performance), but it is important to recognize that this is not guaranteed.”
While it might be tempting to jettison international and emerging equity from your portfolio, the evidence shows that global diversification remains a cornerstone of good portfolio management.
Nobel Prize-winning economist Harry Markowitz famously described diversification as “the only free lunch in finance.” This is one meal you don’t want to miss.