One of the worst-kept secrets of investing is that if you have a properly diversified portfolio, your return will never be as good as that of the best-performing asset class. Of course, it will also never be as bad as that of the worst-performing, either…

There will always be some asset class that does poorly, either in relative or absolute terms. Over the last few years, one of those asset classes has been international stocks. They have underperformed US stocks over the past several years, and they may well do so again this year. Given this recent underperformance, we’ve had some people ask why we continue to include them in our portfolios.

Let’s look at this in two ways:
• The financial theory reasons
• Recent performance, and if something is different this time

We’ll start with the big picture. Our portfolios are designed to capture market returns. Research has shown that it’s impossible to predict (… or guess) consistently what the markets will do in the future, but investors who “own the market” and stay disciplined tend to generate good returns. “Own the market” means staying invested in international stocks.

As of the end of 2018, the US represented roughly 54% of the value of the world’s stock markets. So, 46% of the world’s market value was outside the US. In other words, if we were to skip investing in international stocks, we would miss out on about half of the world market.

It’s important to remember just how interconnected the global economy is today. If you walk into any big box retailer, most of the products you see on the shelves were manufactured somewhere other than the US. One can argue about whether that is a good or bad thing, but it means that the world’s economy is tightly integrated. Global shipping routes give us a clear picture of that.

The world economy is no longer divided into separate markets, where you can safely ignore what is happening on the other side of the globe.
Also, from a pure diversification stand point, we shouldn’t exclude international stocks. We want to own as many securities as possible, in order to eliminate the risks that we’re not compensated for as investors – company-specific, country-specific and industry-specific risks, for example.

International stocks are actually a very good way to diversify. If we look at the historical data, US and international stocks have moved fairly independently from one another. The correlation (a statistical measure of how similar the movement of two series are) between the S&P 500 Index (a proxy for US stocks) and the MSCI EAFE Index (international developed stocks) from January 1970 to July 2016 was only 0.633.

To put that in perspective, over the same time period, the correlation between the S&P 500 Index and the CRSP 9-10 Index (which represents the very smallest companies in the US market) was 0.754. In other words, they are still stocks, but the US and International markets perform reasonably differently through time.

But it’s important to note that just because they perform differently, there is no difference in expected returns.

Data from January 1970 to December 2018, courtesy of Dimensional Fund Advisors

Now, from the data above it may seem contradictory to state that there is no difference in expected returns between US and international stocks. But the key thing to notice here is the standard deviations for the two indices – they’re relatively large numbers, which means that the returns tend to vary widely from year to year. In fact, they vary so much that here is no reliable statistical difference between the average annual returns.

What this means is that it’s possible that the difference is purely random “noise”. We have over forty-five years of data, and we can’t reliably say that either the US or international stocks tend to outperform the other.

We can also see this if we simply look at how often international stocks outperform US stocks, and vice versa.

Monthly data from 1/70-12/18, annual data from 01/70-12/18, courtesy of Dimensional Fund Advisors

So, the two are pretty evenly split. If we were to select a random month, quarter, or year, it’s just as likely that international stocks did better in that period than US stocks.

It’s basically a coin flip whether US stocks will beat international stocks or international stocks will beat US stocks.

Let’s think about coin flips for a moment. Everyone knows that you’re equally likely to get heads or tails, and each flip is independent. If you got heads last time, that doesn’t mean anything for the next flip – you still have a 50% chance of getting either heads or tails.

Let’s say we filled all 63,000 seats of Cal’s Memorial Stadium with investors flipping coins (wishful thinking for Cal fans, I know). Our goal is to find the best coin flipper. Everyone flips their coins at once, and if you flip heads you can stay for another flip, while flipping tails means you have to leave. It would take about 16 coin flips for us to expect to get a winner.

Now, that last person left is not actually the best coin flipper. They were just very lucky. And the same applies to the returns of US and International stocks. Since which will do better is random, we expect to see a whole bunch of streaks – and long streaks every once in a while.

Looking at the historical data, we see those streaks pretty clearly. Using annual returns from 1970 on (which was the start of the MSCI EAFE Index), there are some pretty long streaks. The longest that international stocks have outperformed US Stocks in a row is six years, which has happened twice – from 1983-1988 and from 2002-2007. On the other hand, US stocks have outperformed international stocks for four years in a row three times during this period, most recently from 2013-2016.

As we can see, these (long) streaks can happen. The fact that international stocks have underperformed US stocks for a while is nothing new and it doesn’t mean anything is different this time.

What matters now is what happens going forward, and there is simply no way of predicting what will happen.

So we come back to where we started – wanting to capture long-term market returns. And the way to do that is to stay diversified and disciplined.

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