International equities are a valuable source of diversification
International stocks can act as an important source of diversification, improving a total portfolio’s expected risk-return profile versus a portfolio that includes only US equities. This benefit comes from holding securities in a variety of countries, each reacting differently to market and economic conditions.
Investors can increase diversification by holding securities denominated in various currencies, each of which behaves somewhat independently of the underlying stock price. Different markets and currencies tend to respond to market cycles and world events in their own unique ways, experiencing downturns and upturns at varying times and magnitudes from the US.
By tapping into these offsetting patterns, investors may reduce overall portfolio volatility, providing a smoother ride with similar returns compared with investing in US stocks alone. We can see the diversifying power of international equities in the table below, where we show the average three-year return for an index of US equities compared with a blend of indexes that allocates two-thirds to the US and one-third to stocks outside of the US, rebalancing on a monthly basis. Over the prior 40 years, the average three-year return between the single index and the blend is practically indistinguishable. However, by investing non-US stocks, an investor could have reduced average volatility by a meaningful margin.
Average annualized three-year return and volatility for US and US/international indexes, 12/31/1972–6/30/2020, rolling monthly
Sources: MSCI, Bloomberg, Parametric, 6/30/2020. Index performance is provided for illustrative purposes. It is not possible to invest directly in an index. Indexes are unmanaged and do not reflect the experience of any investor. Index performance does not reflect the deduction of management fees and transaction costs which would reduce the returns presented. Index performance is not intended to reflect the performance of any strategy offered by Parametric. Past performance is not indicative of future results.
International equities are too big to ignore
When home-country bias leads US investors to favor US stocks heavily, it cuts them off from a significant part of the global investment universe. The MSCI ACWI Index’s allocation to non-US developed countries is 30%. This means that if a portfolio holds only US stocks, it essentially ignores about a third of the opportunity set—nearly half if one considers all non-US markets, developed and emerging.
MSCI ACWI geographic weights
Sources: MSCI, FactSet, 6/30/2020. For illustrative purposes only. It is not possible to invest directly in an index. All investments are subject to the risk of loss.
The bottom line
Home-country bias and the pull to buy local is real, and it only grew stronger during the historic US bull market run over the past decade. But this bias leaves US investors vulnerable to an extended period of US equity underperformance, and it could have a lasting negative impact on portfolios. Investing in international equities allows investors to take advantage of the potential periods of international outperformance while gaining the benefits of diversification at the portfolio level. At a minimum the result may be a portfolio with a similar expected return paired with lower expected volatility than a purely homegrown US equity portfolio.
For a fuller perspective on investing in international equities, download our whitepaper.
Global market investing (including developed, emerging, and frontier markets) carries additional risks or costs including but not limited to: political, economic, financial market, currency exchange, liquidity, accounting, and trading capability risks. Future investments may be made under different economic conditions, in different securities, and using different investment strategies.
The MSCI USA Gross Total Return Index is designed to measure the performance of the large-cap and midcap segments of the US market. With 616 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US. The MSCI EAFE Gross Total Return Index is an equity index which captures large and mid cap representation across 21 Developed Markets countries around the world, excluding the US and Canada. With 902 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI All Country World Index (ACWI) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. "MSCI” and MSCI Index names are service marks of MSCI Inc. (“MSCI”) or its affiliates. The strategy is not sponsored, guaranteed or endorsed by MSCI or its affiliates. MSCI makes no warranty or bears any liability as to the results to be obtained by any person or any entity from the use of any such MSCI Index or any data included therein.