It is commonly agreed that one of the main pillars of prudent investing is diversifying your investments. While most investors will agree with that statement, in recent years there has been more resistance when it comes to investing internationally. This is not without cause. Over the past decade, the US stock market has significantly outperformed the international market. Using Vanguard index funds as a proxy, as of July 28, 2023, the Vanguard S&P 500 fund (VFIAX) returned an average of 12.57% a year, while the Vanguard Total International Stock Index (VTIAX) only returned an average of 4.86% a year.

Since the US stock market has performed so much better over the past decade and many large US companies do business internationally anyway, it raises the question of whether direct international investment is needed at all. Despite the underperformance of international funds in recent years, we believe there are many strong reasons to continue to invest internationally.

Domestic and International Outperformance Tend to Come in Cycles

In previous posts, we have talked extensively about the trouble of trying to time the market. You have to time correctly not only when you get out but also when you buy back in. It’s challenging enough to time it right the first time and twice as difficult – if not impossible – to get it right again. That’s why we advocate so strongly for a buy-and-hold strategy with a diversified portfolio.

While this past decade has shown US stocks greatly outperforming international ones, this has not always been the case. In fact, the over- and underperformance of foreign stocks tend to come in cycles. Over the past 30+ years, there have been numerous periods of foreign outperformance compared to US stocks (see the chart from Hartford Funds below). This latest period of US outperformance has been one of the longest in history, but that does not necessarily mean it will continue forever. While past performance does not guarantee future returns, using history as a guide, there is a good chance that sometime in the future, there will be a period of foreign stock outperformance again.

But just like trying to time the market by selling at a high and buying at a low, trying to time when US and international outperformance will swap positions is another fool’s errand. The best way to ensure that you’re participating in any market growth is to buy and hold and continue to stay invested – and this includes keeping a portion of your portfolio invested in foreign stocks. If/when foreign stocks begin to outperform US investments, if you don’t currently have an allocation to them, you may miss a significant portion of their rise.

Investing Internationally Does Not Necessarily Mean Investing Blindly

Just because we advocate having a portion of your investment portfolio in international stocks does not mean we advocate investing indiscriminately. There are additional concerns and risks when it comes to investing in foreign companies, and it’s important to take these risks into consideration. Specifically, foreign stock markets are regulated by the governments of their respective countries. This means that we, as US investors, are foreign investors in those markets and there may be additional considerations when choosing which countries to invest in, such as geopolitics and foreign relations, that go beyond wanting to invest in a diversified portfolio.

A good example of this is the Russian invasion of Ukraine. As we’ve written about previously, Dimensional Funds, the main fund company we use, announced in March 2022 their proactive decision to divest from Russian stocks. This also exemplifies the importance of maintaining a diversified international fund that consists of lots of different individual companies. Although they moved to divest quickly, the total exposure to Russian stocks was mostly negligible (less than ½ of 1% of their emerging markets funds).

While the divestment from Russian stocks was mostly universal among fund companies, other investing decisions may require more discretion. Unlike with Russia, there is no law or regulation that prohibits investments in Chinese companies. However, Milestone has made the decision to specifically avoid investing in Chinese stocks in most portfolios because of the governmental risks associated with those investments. Will Chinese stocks outperform the overall emerging markets category? We don’t know. Will the Chinese government restrict and prohibit foreign investors from buying or holding Chinese stocks, leaving current investors out to dry? We also don’t know. But considering the risks and concerns with the Chinese government in general, we made the proactive decision to use an emerging market fund that excludes China. Is the fund still well diversified among many different countries? Yes. But the main difference is that it excludes all Chinese stocks and reallocates that portion to the other countries that make up the emerging market category.

This is another reason why it is important to know what investments you hold and why. When investing in stocks, especially international ones, there are other considerations outside of just maintaining a well-diversified portfolio.

Global Portfolios Provide Additional Diversification

There has been a phenomenon between US and international stocks in recent decades: their correlation has increased. This means that US and international stocks tend to move in the same direction more of the time. When US stocks go up, international stocks tend to go up. When US stocks go down, foreign stocks tend to follow. The higher the correlation, the lower the diversification benefits because the compared investments tend to move with each other more closely. With this correlation increasing over the past few decades, many wonder whether international investments provide enough diversification to warrant a separate allocation. There are two reasons why we believe international stocks should still be a separate asset class in a well-diversified portfolio.

The first reason is that while yes, correlations have increased, US and international stocks are still not, and likely will never be, perfectly correlated. What this means is that while the diversification amount has reduced over time, there is still some measurable benefit to specifically holding foreign stocks. While the trend of increasing correlation may continue, this is not guaranteed. In the same article referenced above, correlations between US and foreign stocks did decrease in 2022. We believe that even at fairly high correlations, international stocks still do provide valuable diversification. And just like trying to predict stock market movements, there at times can be correlation surprises, as exhibited in 2022.

Second, there is more than one way to measure true diversification. As referenced above, correlation is one of the most common ways of measuring meaningful differences between two investments. Another measurement is looking at how portfolios compare over the long term. Of course, past performance does not guarantee future results, but when examining historical portfolios over longer time periods, according to this research, international exposure helped portfolios over the long term. As previously discussed, because of the increase in correlations, this article agrees that in the short term, international stocks may not provide as much diversification as in the past. But when zooming out to a longer time horizon, foreign stocks still provide significant diversification value and should not be dismissed entirely.

Foreign Valuations Look Better Compared to the US

One of the main reasons Milestone predominantly uses Dimensional Funds is because of their extensive research and history with markets. Their research discovered various factors that we discussed in a previous blog. As mentioned in the blog, one of the main factors discovered was a value premium. When comparing international stocks to US ones, based on the value metric, international stocks are better priced. As we’ve mentioned before, past performance does not guarantee future results; but if you believe in the research on value investing like we do, there is a strong rationale for maintaining a separate allocation to international stocks.

A commonly referenced valuation metric is the price-to-earnings (P/E) ratio. This measures the price of a stock (or a group of stocks) and compares it to the earnings of the company(s). So, if a stock is valued at $100 and its annualized earnings are $10 a share, the P/E ratio would be 10. Alternatively, if a stock is priced at $1,000 and its annualized earnings are the same at $10 a share, its P/E ratio would be 100. The second company is expected to grow more quickly to justify its higher price point. This is the key difference between “growth” companies and “value” companies: how they are priced based on their expectations for future growth. As of June 30, the P/E ratio of the Vanguard 500 fund was 19.93, while the international fund was 12.95, meaning that the international fund has a heavier tilt toward value companies than the S&P 500 does.

Another metric we can look at is the price-to-book (P/B) ratio. This was the valuation metric most closely analyzed by the Fama and French research that we discussed in our previous blog on factors. Essentially, the P/B ratio compares the value of a stock to its total book value (total assets minus liabilities). For example, if all the outstanding stock of a company were valued at $750 million (market cap) and the book value of the company was $250 million, its P/B value would be 3 (750/250). Like with the P/E ratio, the lower the number, the better the valuation because the company has more assets compared to its stock market value. When comparing the same two funds, as of June 30, the Vanguard S&P 500 fund’s P/B ratio was 3.72, while the international fund’s was 1.51.

Like international investing, value investing has gone out of vogue in recent years because of its underperformance compared to growth stocks. While past performance does not guarantee future results, the research is clear that historically, over the long term, investors that have stayed the course have been rewarded when tilting their investment portfolios toward value. Like the international to US stock cycles, historically the value premium realized has come in cycles too, with more or less realized at certain periods of time. This isn’t to say that value stocks will outperform growth stocks going forward (especially with the meteoric rise in tech stocks over the past few months); however, value stocks made a significant comeback through 2022. Time will tell if this trend continues, and we certainly cannot predict what the market will do. But looking at long-term, research-based analysis, international stocks are priced better than US ones, which likely warrants allocating at least some of your portfolio explicitly to foreign stocks.

Wrap-Up

Diversification is a vital aspect of any proper investment portfolio. Although international investments have received criticism for underperformance in recent years, that does not mean you should avoid foreign stocks entirely. There are many good reasons to continue to allocate a portion of your portfolio to international stocks, three of which we discussed in this post today.

Investing can be complex, especially when it comes to determining the appropriate amount of international exposure. If you need help with your investments or financial plan, please reach out to our team.