The question of whether to invest in international stocks is perpetual. Especially as the S&P 500 (a broad-based index of the U.S. stock market) has delivered astounding returns in the last decade (over 12% annually compared to just 4% for international stocks, proxied by the Vanguard VXUS ETF), investors are questioning whether they really need anything beyond an S&P 500 index fund for their stock exposure.
S&P 500 index funds are cheap (you can find them with expense ratios 0.05% or lower), are available in just about every type of account (401(k)s, IRAs, 529s, HSAs, etc.), and have been an incredible place to be in recent years.
But before delving more into the relative merits and downsides of “international” stocks, we should first ask: What is international to you?
Home Country Bias
Home country bias means holding more than your country’s representative share of the global stock market in your personal portfolio. For example, if your country's stock market is 5% of the total global stock market and you hold 20%, you’re showing a bit of home country bias.
It may surprise U.S. investors, but investing heavily in your own country’s stock market is pervasive around the world. Canadians, English, Australians, Japanese… they all have a strong home country bias.
Data from 2014 showed U.S. investors held nearly 80% of their stock allocation in U.S. stocks, while the U.S. market share was only 50% of global stocks at the time. Even markets like Australia, whose stocks make up only 2.4% of the global market, found their citizens holding almost two-thirds of their stocks in Australian companies.
And this bias is found not just in individual investors, institutions exhibit the same bias. A study of European pension funds found they held significantly more domestic stock than their country's relative global exposure.
To understand whether you are exhibiting home country bias, you must understand what the global stock market looks like today.
Global Stock Market
As things sit at the end of 2022, the global stock market looks something like this:
Source: J.P. Morgan Guide to the Markets
At 60% of the world’s total stock market, the performance of global stocks is going to be highly dependent on U.S. stocks. And if you decide to hold all of your stock exposure in U.S. stocks, you’re exhibiting some bias, but nowhere near as extreme as investors with smaller stock markets.
But given how well U.S. market performed, why should you consider a more global allocation?
Long Periods of Underperformance
Although U.S. stocks have outperformed global stocks over the last decade, there have been long stretches of underperformance from U.S. stocks.
The graph below shows cumulative periods of U.S. outperformance (dark gray) and cumulative periods of International stock outperformance (purple). We are clearly in the midst of a long and massive stretch of U.S. stock outperformance.
And with this outperformance has come a supportive narrative and comfort in having a home country bias.
But would you feel the same way if the last three years looked like the following for U.S. vs. international stocks (1986-1988)?
What if you lived through these six years without any international stock exposure (2002-2007)?
Living through these periods of underperformance can be incredibly challenging and lead to switching horses at precisely the wrong time. This is one of the biggest hurdles in any concentrated portfolio strategy: you must be willing and able to live through periods of significant underperformance and stick to your guns. And you must also shut out the "noise" from talking heads, pundits, and media.
To hammer this point home once more, let's look at returns from 2000-2007 for U.S. stocks (blue) compared to international developed nations (red) (think Germany, Japan, England) and emerging markets stocks (yellow) (think Brazil, Russia, India, China):
Through the first 7 years of the new century, emerging markets stocks trounced their U.S. and developed counterparts, gaining 15% per year, including +20% for 5 consecutive years.
And this was after the U.S. market suffered through the brunt of the Dotcom crash, the September 11th attacks, a recession, and a new war in the Middle East. The narrative at the time was the U.S. is a slowing "old world" economy and the future was in these emerging market up-and-comers. Would you have stuck to a U.S. allocation at this time or gone global?
Taking a global stock stance reduces the risk of significant deviations from other major markets.
Although a common refrain of the U.S.-stock-only crowd is "U.S. companies operate globally so you already have global exposure through the S&P 500," this is only partly true.
Yes, U.S. companies operate globally. However, the types of companies domiciled in the U.S. differs significantly compared to international markets.
Below is a comparison of the U.S. stock market (proxied by the Vanguard Total Stock Market ETF) compared to the International stock market (proxied by the Vanguard International Stock Market ETF) as of December 2022.
As you can see, there are significant differences in the composition of these markets. And given the strength of the Technology sector in the last decade, perhaps it's not so surprising that the U.S. stock market, whose four largest holdings are Apple, Microsoft, Amazon, and Google, has dominated foreign stocks, whose largest holdings are Taiwan Semiconductor and Nestle.
Investing in a company or companies that operate globally does not provide the same diversification as the total stock market.
Apple, Exxon, and McDonald's all operate globally. But would you invest in just one of these companies to provide a globally diversified portfolio?
Investing without the Benefit of Hindsight
With the benefit of hindsight, it's clear that U.S. investors should not have strayed from their shores. U.S. investors would have been better off from a performance and risk-reward perspective by investing only in domestic stocks.
And U.S. investors are not alone in this regard. In a study of 32 developed stock markets from 1974-2021, eight nations had better risk-reward metrics when compared to a global stock portfolio.
Chilean, Mexican, Swedish, and a few other investors would have been better off eschewing global diversification in favor of a wholly domestic stock portfolio.
But the other 24 developed nations (75% of the markets studied) would have enhanced their risk-return through global diversification.
Relative Valuations and Greater Expectations
Thanks in part to their impressive run, U.S. stocks continue to trade in-line with historical valuations. And prior to 2022's declines, the U.S. market was very expensive relative to historical valuations.
International stocks are trading at average or below-average valuations relative to history. And while valuations are not a great metric to predict short-term performance, they have shown value as a longer-term indicator.
Source: J.P. Morgan Guide to the Markets
Partly due to lower current valuations, major investment firms are also expecting higher returns for international markets over the next 5-15 years.
- Vanguard anticipates 4.7%-6.7% for U.S. stocks and 7.4%-9.4% for international stocks over the next decade
- J.P. Morgan anticipates 8% for U.S. stocks and closer to 10% for international stocks over the next 10-15 years
However, despite these higher return expectations, choosing to overweight international stocks is certainly not the point of this post. The reason to highlight these expectations is to give a sense of what the major investment firms expect over the intermediate-term.
Although the global market has gone through a historically abnormal stretch of U.S. stock dominance in terms of length and magnitude, this post is not intended to suggest underweighting U.S. stocks or eliminating them from your portfolio.
Instead, I would suggest the following steps:
- Evaluate your current investment portfolio. What's the current mix of U.S. and international stocks?
- Are you exhibiting a home country bias? Is this intentional?
- Ask yourself: How do you want your portfolio to be structured for the next several decades (or however long your time horizon)?
Bryan Minogue CFP®, CFA is the Founder of Kardinal Financial, a fee-only, fiduciary financial advisor serving young families and professionals. This post is for information purposes only and is not intended as financial advice.