Investors have not been doing a happy dance during December. As of last week the S&P 500 index, made up of the largest US publicly traded stocks, was down 10 percent so far this month. It could be worse. Most of the component stocks of the index have entered a bear market, which means they have declined more than 20 percent from their tops. The S&P itself is down 15 percent from its September high.
But our interest in stocks is not confined to our national borders. Don’t believe me? If you own a target retirement fund, I can almost guarantee that you’re invested in foreign stocks. Too bad international stock markets are not faring well. The MSCI World Index (except US) is down over 14 percent year to date and is in a bear market.
In fact, international stocks have been a relative drag on performance for years. Over the last 3 years, the world index has averaged 5.1 percent annual growth while the S&P 500 has been humming along at 10.5 percent annually. Longer periods do close the gap, but there is persistent underperformance of large world stocks compared to their domestic counterparts.
Vanguard founder John Bogle is well known for his relative disdain of international investing. He has encouraged individual investors to make their international stock holdings a maximum of 20 percent of all stocks in their portfolio. So if you were in a classic 60 percent stock and 40 percent bond portfolio, following this advice you would hold at most 12 percent in international stocks. The apple falls far from the tree in this circumstance, as Vanguard’s own target retirement funds have fully 40 percent of their stocks invested overseas.
Among the most compelling reasons to invest internationally is that about half of the value of world stock markets is outside of the US. The purpose of holding stocks is to be an owner of tiny slices of thousands of businesses. Would you rather participate in the growth in companies around the world, or confine your scope to the US? While the US has been a great place to invest, the economies of other countries will continue to grow in some cases faster than ours. All things being equal, I’d rather be a global rather than a purely domestic investor.
Let’s say you agree that global investing sounds inherently better than a sole US focus. But what about the relatively poor performance of international stocks compared to domestic ones? We don’t want to have our financial independence suffer because of our global outlook.
The more long-term perspective tells a different story. Consider two portfolios: a globally diversified 60/40 portfolio and a US focused 60/40 portfolio. The only difference in the portfolios is that the global one has 30 percent of its stock holdings invested internationally. Both have 40 percent in five year US Treasury bonds. We’re also rebalancing on an annual basis. In doing so, we’re systematically reducing our risk, buying what’s cheap, and selling what’s expensive.
From mid-1970 through October 2018, the US focused portfolio had a 9.8 percent annual return. The global one averaged 9.7 percent per year. In short, the portfolios performed almost exactly the same. This should validate that a global investment philosophy doesn’t naturally translate to subpar performance. Given that international stocks have lagged domestic stocks for the last five years, it may be international’s turn to achieve better returns in the years to come. We can’t time the market, but with similar multi-decade records for international and domestic stocks the future may be brighter to invest overseas.