“Reports of my death have been exaggerated,” Mark Twain
The last five years have been about as good as it gets for big American stocks. Indeed, the S&P 500 has doubled in value since January 2010. For international stocks, not so much. International developed country stocks have only grown by 35% in value over that time, while emerging market stocks have only increased by 17.5%.
So let me get this straight, you might ask. If I had invested $100,000 in the S&P 500 nearly five years ago, it’d be worth $200,000 today. However, if I had invested that same $100,000 in the international developed stocks, it’d be worth $135,000. Even worse, if I’d put that money into emerging market stocks, it’d be worth $117,500.
Why on earth would anyone invest in international stocks? Looks like the good ol’ U.S. of A. does just fine, thank you very much. Take that France! (Actually, I kind of like France, but don’t tell anyone.)
Well, it turns out that if you give it enough time, investing internationally can be very helpful in smoothing out the roller coaster ride that comes with owning stocks. That’s because investing internationally increases your sources of returns. (Factor diversification does the same thing, see here and here.) Think about it, what’s safer for a business, relying on one customer or having several.
Suppose for an instance that there are two siblings – John and Jane – each of whom inherit corn farms in Iowa. John is happy to stick with owning the corn farm; however, Jane is nervous about having so much of her money tied up in one farm, in one area, growing one crop, so she sells half of her corn farm. With half of the proceeds, she buys part of a soybean farm in Germany. With the other half, she buys part of a Kobe beef ranch in Japan.
Now, Jane doesn’t have anything against corn or Iowa, nor does she expect that over the long run, she’ll necessarily earn any additional money from her other farms. (In a normal year, all of the farms tend to earn about the same amount of money.) She just wants to spread her risk and cut back on those big ups and downs than tend to go with farming.
Now, let’s further assume that for a couple of years, the weather in Iowa is perfect for growing corn. On top of that, corn prices are very high. This results in huge profits for the Iowa corn farms. At the same time, heavy rains in Germany (trust me, I’ve lived there, it happens) and falling beef prices hurt those farms’ profits for a couple of years. As a result, John does extremely well for those years, while Jane does considerably worse, though she’s still making a good return on her money.
Given those circumstances, was Jane “wrong” to have sold some of her Iowa farm and purchased parts of farms in Germany and Japan?
Some people would argue that she was mistaken. After all, she didn’t earn as much money as John over those three years, so it must have been the wrong decision.
I think that those people are confusing strategy and outcome. Jane’s strategy was sound, and, over the long run, it has been a superior strategy to John’s. But we can never know beforehand which investments will do best, and there will always be parts of the market (in this case the Iowa corn farm) that dramatically outperform. That doesn’t make the strategy of diversification wrong. Indeed, in our little parable, just ask the German soybean farmer or Japanese rancher if they would have liked some more diversification.
The S&P 500 has done extremely well over the past five years, just like John’s corn farm. However, just like farms have times of boom and bust so does the S&P 500. Let’s take a look at how the S&P 500 fared during the 1970s compared to international developed country stocks (using the MSCI EAFE index):
Annual Rate of Return (1970-1979) Growth of $100,000
S&P 500 5.9% $176,760
MSCI EAFE 10.1% $261,500
The history of U.S. and foreign stocks is one long game of leap frog. International stocks go on a run for several years (usually around five), followed by similar returns, followed by U.S. stocks taking off for several years and jumping ahead. Of course, occasional dramatic drops in both U.S. and international stocks punctuate that leap frog game.
So what if like Jane, we spread our risk around? Does it help smooth out the ride? You bet it does. Let’s take a look at our two previous examples of outperformance by either the S&P or international developed stocks and see what happens when we spit our money even between them.
S&P 500 5.9% 15.5%
MSCI EAFE 10.1% 6.5%
S&P/EAFE 8.3% 11.0%
Now, of course, if we knew beforehand which part of the market would outperform, we would have been all-in on international stocks in the 1970s and U.S. stocks the past five year years. But, alas, my crystal ball is as cloudy as ever, so I spread my money around, knowing that while I won’t hit a home run, I won’t strike out either.