Everyone can access diverse investment opportunities worldwide in today’s interconnected global economy. International diversification is a strategy that has garnered attention for its potential to enhance portfolio performance and mitigate risk. However, many United States investors tend to have a US-centric portfolio, overlooking the potential benefits of international diversification.
Although it may be tempting to concentrate exclusively on the domestic market, discerning investors recognize the importance of expanding their perspectives and delving into global prospects. Mulland Fraser Tokyo Japan reviews why international diversification is crucial for portfolio construction and debunks common arguments against it.
Theoretical Foundation
Modern financial economics theory, pioneered by Harry Markowitz and Bill Sharpe, emphasizes the importance of diversification in constructing portfolios. Markowitz’s portfolio selection theory, published in 1952, showed that diversifying across assets with different correlations can increase expected returns without increasing risk. This concept revolutionized the field and introduced the notion that the risk of a portfolio is not solely determined by the individual risk of its underlying assets but also by the extent to which they move together.
Building on Markowitz’s work, Sharpe developed the Capital Asset Pricing Model (CAPM) in 1964. The CAPM suggests that investors should diversify their portfolios for return and risk. According to the model, in an efficient market, all assets are priced so that the market portfolio becomes the mean-variance optimal portfolio.
US Stock Market Dominance
The dominance of the US stock market is undeniable. It is well-diversified across industries and represents over 50% of the global stock market. Many US companies also generate significant revenue from international markets. These factors make investing in US stocks compelling, especially when considering historical outperformance.
Nonetheless, it is essential to approach this viewpoint with scrutiny. Despite the impressive performance of the US stock market throughout the years, it is attributing a substantial portion of its success to fluctuations in valuation rather than inherent excellence. When accounting for these valuation changes, the margin of outperformance of US stocks significantly diminishes.
Long-Term Perspective
While US stocks have outperformed international stocks in specific periods, there were periods where the opposite was true. For example, US stocks underperformed global stocks from 1950 to 1989 and 2000 to 2009.
When considering rolling 10-year periods from 1900 to 2022, US stocks beat global ex-US stocks only 59% of the time. This data highlights the importance of taking a long-term perspective and not being swayed solely by the recent performance of a particular market.
Resilience in Downturns
One crucial advantage of international diversification is its ability to provide resilience during periods when US stocks underperform. Historical data indicates that international stocks have held their own and even outperformed US stocks in some cases when the US market experienced downturns. This resilience attributes to the global markets’ diversity and varying economic cycles.
Increased Correlations and Additional Portfolio Improvements
Correlations among markets have indeed increased, especially in the short term. However, the benefits of international diversification for long-term investors remain. Research suggests that correlations among large-cap growth stocks across countries have risen more significantly than correlations among small-cap value stocks. This finding implies that international and small-cap value stocks can provide additional portfolio improvements beyond what global market indexes offer.
Inefficiency of Domestic Stocks with International Revenue Exposure
Some attempt international diversification by owning domestic stocks with international revenue exposure. The reasoning behind this is that these companies have exposure to global markets. However, empirical evidence negates this claim. Stocks of national firms tend to move closely with their respective nationwide market indexes, making them poor tools for diversification.
On the other hand, adding international equities to a domestic index has improved portfolio efficiency substantially. Furthermore, diversification across countries within an industry has proven more effective for risk reduction than industry diversification within a single country. This finding stresses the significance of country diversification and the limitations of relying solely on domestic firms with international revenue exposure.
Long-Term Perspective on Risk and Returns
When constructing a portfolio, Mulland Fraser Tokyo Japan insists on considering risk and returns over the long term. While short-term correlations may fluctuate and increase, long-term investors can still benefit from international diversification.
Research has demonstrated that the main driver of rising correlations is financial vision. In contrast, the correlation of discount rate shocks resulting from changes in interest rates does not reduce the benefits of global diversification for long-term investors.
Protection Against Poor Country Returns
International diversification protects investors against holding concentrated positions in countries that may experience poor long-term returns. Predicting which countries will be the top performers in the future is nearly impossible, making broad global diversification the most sensible approach for most investors.
An extensive analysis of various developed markets from 1890 to 2019 yielded compelling findings. The study revealed that a representative investor, who strategically incorporated international stocks into their portfolio, experienced a notably reduced likelihood of suffering a loss in purchasing power compared to those solely invested in domestic stocks. This advantage extended over an extended time horizon of thirty years, signifying the enduring benefits of international diversification.
The comprehensive research demonstrated the potential of international stocks to safeguard against wealth erosion and inflation, presenting a compelling case for investors to consider incorporating global market opportunities into their long-term investment strategies.
The Bottom Line
In conclusion, international diversification is a vital component of sensible portfolio construction. While the US stock market has demonstrated impressive performance over the years, there may be better strategies than relying solely on it for investment. Theoretically and empirically, investors must recognize the benefits of international diversification. It provides the potential for increased returns, reduced risk, resilience during US market downturns, and protection against poor domestic returns.
Investors should not be swayed solely by past performance or the recent success of a particular market. Current market prices reflect past success and high expectations, making future returns less likely to mirror the past. Therefore, broad global diversification across countries is the most prudent approach for long-term investors seeking to create and preserve wealth.
Mulland Fraser Tokyo Japan encourages investors to embrace international diversification and consider the broader opportunities available in global markets. By doing so, investors can access the potential benefits of a truly diversified portfolio and enhance their long-term investment outcomes.
