In our last post, we looked at how bonds can fit into a diversified portfolio. Today, we are looking overseas, and why you might want to own international stocks to be truly diversified. When you look at the stock (equities) portion of your portfolio, you have an important decision to make. Do you load up on companies you are familiar with, those companies based in the US? Or do you branch out and consider owning companies based in countries like Germany, England, China, or South Korea? Just by listing those countries out, we’ve probably invoked some emotion you may have, possibly stemming from a recent article you read, or a recent television news story you watched.
It’s Understandable to be Nervous About International Stocks
If investing in foreign countries makes you nervous, know that you aren’t alone. In fact, if you were to look at a German investor’s portfolio, you’d likely see a heavy weighting towards German companies. This is a behavioral bias known as home country bias, and it’s a global phenomenon. For the sake of this post, we’ll stick with the vantage point of an American investor living in the US.
If you watch the nightly news, you might be led to believe that things outsight our borders aren’t going so well. To the south, we see a massive migration from countries amid political and economic turmoil. In Europe, we have a continent that still struggles to recover from the financial crisis more than a decade on. In Asia, we have an escalating trade war and a dictator that has fired two rounds of missiles in recent days.
Moreover, just looking at the performance of foreign stock markets in the last decade might be enough to turn you away from adding foreign stock investments to your portfolio.
Source: ycharts.com
We’ll attempt to make a case for why foreign stocks still have a place in a diversified portfolio.
Mean Reversion
An analogy we like to draw involves baseball. Baseball is a great sport for fans of statistics because of the large number of games played. We get to deal with a large sample size, which makes the data more relevant. Take a player like Joey Votto of the Cincinnati Reds. He’s played more than 1,600 games during his professional baseball career, and over that time, has a batting average of .308 (a batting average about .300 is considered excellent).
Nine of the last eleven seasons, his batting average was above .300. He is currently batting .206, a full .102 below his career average (a substantial decline). In baseball, we would look at this and say he is in a slump. He’s probably not forgotten how to hit a baseball, he just may be working through some things in his game, and we would expect, based on a large sample of data (+1,600 games) that at some point he will figure it out and hit closer to his long-term average.
The same argument could be made for international stocks. The MSCI EAFE Index, which began tracking stock markets across Europe, Australia, and Asia in 1970, has had an average annual rate of return of about 6% per year. However, over the last 15 years, the index has returned less than 5%. Perhaps this is the “new normal,” and we should lower our expectations. However, foreign stocks might be in a “slump” like Joey Votto, and a reversion to the long-term average is a possibility.
International Stocks and Diversification
If you’re a US investor, you’ve likely got a portfolio that’s heavy in US companies. This is an extreme example (probably the extreme example) but let the Japanese markets serve as a cautionary tale. If someone living in Japan thirty years ago had all of their money in Japanese stocks (we’ll use the Nikkei 225 index as a proxy), they have likely experienced nothing but losses. On May 14, 1990, the Nikkei 225 opened the day at 31,541. Thirty years later, the Nikkei opened the day at 20,870. This is the classic case on why you might want to avoid home country bias and diversify by investing across the globe.
Good Value
Stock market valuations are measured in many ways, but a commonly used metric is a price-to-earnings (P/E) ratio. The formula for a P/E ratio is the market value per share divided by the earnings per share. Typically, the lower the P/E ratio, the more undervalued the asset is. The current P/E ratio for the S&P 500 is about 21.5. The MSCI EAFE has a P/E ratio of about 15. This is to be expected, as we’ve seen a massive increase in US market valuations since the Great Recession and a large divergence in valuations between US and foreign markets. If you’re a value investor, it’s hard not to take a look at stock markets overseas.
Now, we don’t want you to assume that you should always own international stocks, but instead that it might be a good idea to diversify overseas. This post is just a guide to understanding the potential long-term benefits of global diversification. If you want a professional opinion on how international stocks might fit into your retirement plan, we’re always happy to help. Our financial planners will sit with you and review your portfolio and your overall retirement plan. If you’re interested in talking with one of our financial planners, give us a call at 913-393-1000 or schedule a complimentary consultation below and someone will be in contact to schedule a time with you.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.