When financial advisors talk about diversification, they don't mean you should buy five large-cap U.S. stocks and call it a day.
Instead, they are referring to a concept called asset allocation, which involves dividing an investment portfolio into different types of stocks and bonds, tailored to a client's specific goals, risk tolerance and time horizon. The securities represent different asset classes, such as fixed income, large-cap stocks, small-cap stocks, domestic stocks and international stocks.
But given the performance of U.S. equities relative to their non-U.S. counterparts over the past several years, does it make sense to allocate internationally?
Here are some factors investors and their advisors need to consider when determining how much exposure to international stocks is appropriate:
Performance: U.S. stocks vs. international stocks.
Reasons for international diversification.
Risks of international diversification.
Performance: U.S. Stocks vs. International Stocks
The S&P 500, despite being a large-cap index, is typically used as a proxy for the broad U.S. market.
Investors who allocated to the iShares Core S&P 500 ETF (IVV) would have gotten the following returns in various rolling time frames:
1 year: 14.61%
3 years: 18.56%
5 years: 16.02%
10 years: 14.63%
15 years: 10.22%
To understand the value of non-U.S. investing, it's important to see the returns of the iShares MSCI EAFE ETF (EFA), which tracks an index of large- and mid-cap developed-market stocks, excluding the U.S. and Canada.
The EFA ETF's returns were:
1 year: -0.10%
3 years: 7.33%
5 years: 6.67%
10 years: 6.20%
15 years: 2.82%
With domestic equities being the clear winners over the past 15 years, what role should international stocks play in a portfolio?
Tim Bain, president and chief investment officer at Spark Asset Management in Statesville, North Carolina, notes the role U.S. companies played in the global economic boom of the past decade. For that reason, he says, it's understandable that U.S. investors have a home-country bias and are more focused on domestic stocks.
However, U.S. stocks have not always outperformed international indexes.
"For the five years leading up to the great financial crisis, international markets outperformed the U.S., and in the mid-'80s, there was significant international outperformance," Bain says.
Bain cites a quote attributed to Nobel Prize laureate Harry Markowitz: "Diversification is the only free lunch" in investing. Bain points out that while the slow-growth, low-interest-rate environment of the past 10 years has been good for U.S. growth stocks, there has been a recent rotation into value.
He notes that the EFA ETF has less than 9% of total assets in the tech sector, which is generally high-growth. Meanwhile, the S&P 500 is made up of more than 25% technology names. That discrepancy bodes well for international investors, Bain says.
Reasons for International Diversification
Jennifer Sireklove, managing director of investment strategy at Seattle-based Parametric Portfolio Associates, cautions investors to view diversification as a strategic decision, rather than a matter of market timing.
"Investments that have gone up a lot can still go up more. And diversification can look foolish in hindsight when you've invested in the underperformers," she says. "But the reason to diversify is that you just never know what tomorrow will bring."
Even in the current market environment, Sireklove emphasizes the need to stick with an investment strategy that includes broad geographic diversification.
"Unless investors have the utmost confidence in their ability to consistently pick winners and avoid losers, geographic diversification means you don't end up putting too many of your eggs in the wrong basket," she says.
Sireklove adds: "In our experience, diversification works best when you stick to it, through thick and thin. Trying to make too many tactical adjustments undermines the value of diversification."
Not every advisor or asset manager takes the same approach to global investing.
John Lau, principal and managing director of LFS Wealth Advisors in Burlingame, California, tracks the charts of various asset classes. He points out that the technical readings for international and domestic equities remain volatile and don't look good relative to simply holding cash.
Nonetheless, Lau is a proponent of international investing and broad diversification.
"The technicals are still favoring U.S. stock dominance, although international allocation should be part of the overall portfolio mix," Lau says.
He also notes that the U.S. stock market is rotating from growth to value stocks and that in the short term, commodities are outperforming every other market sector.
"Currently, Latin America seems to have the best relative strength in the international stock arena," Lau says. "Asia-Pacific emerging markets may also be considered, although it is necessary to watch your position size and stock loss to manage risks."
Risks of International Diversification
A general rule of thumb is to have exposure to emerging markets in an investment portfolio, says Cassandra Cummings, a wealth and investment strategist at the Stocks & Stilettos Society, an online community for female investors.
"Emerging markets can consist of countries in the South America and Southeast Asia regions of the world," she says. "However, that amount depends on your time horizon and risk tolerance, since emerging markets can be seen as relatively volatile, especially when faced with current world events such as a global pandemic."
Cummings says investors should use caution when allocating internationally, given the instability of many foreign markets.
"The geopolitical landscape is inherently uncertain, and the U.S. government can halt trading on international companies, as we recently observed with a list of companies from China," she says.
Cummings is referring to a Securities and Exchange Commission list of five Chinese companies that may face delisting due to ties with China's Communist Party or other foreign governments. That list was published in March, resulting in sharp declines in those stocks and other China-based equities.
Cummings recommends waiting until the Russia-Ukraine conflict is resolved before increasing international exposure.
"The uncertainty around the outcome of the war has created a ripple effect around the globe," she says.
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