The historic US bull market run reinforced investors’ home-country bias. But this bias may be hurting your returns and increasing your portfolio’s volatility.
When it comes to investing in the stock market, we tend to hold a large allocation to our country of residence. This home-country bias means many US investors load up on US stocks and hesitate to invest in international equities. But if investors take a longer-term view, they might see that this emphasis on a single country isn’t optimal. Failing to look across borders at shares of non-US companies means you’re overlooking complementary assets—securities that may zig when the US zags.
Here are three reasons why a preference for buying local may put your portfolio at a disadvantage.
US equities won’t outperform forever
If this first reason sounds familiar, that’s because it is. Investment strategists issued this warning repeatedly throughout the US market’s 11-year bull run. These warnings were meant to remind investors that the historic bull market would end at some point—which it abruptly did in March—and they should consider what that would mean for their portfolio.
Consistent outperformance from US equity markets isn’t the natural state of affairs. As shown below, stock market leadership has alternated between US and international equities numerous times over the past four-plus decades. There have been lengthy periods of both outperformance and underperformance of US stocks relative to international stocks (international refers to developed markets outside the US, typically taken to be those countries represented by the MSCI EAFE Index).
Annualized three-year excess return of the MSCI USA Index vs. the MSCI EAFE Index (gross TRs), rolling monthly
Sources: MSCI, Bloomberg, Parametric, 6/30/2020. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index. Past performance is not indicative of future results. All investments are subject to the risk of loss.
The chart above shows distinct periods of international dominance, including a phase in the 1980s when Japan’s bull market crushed that of all other countries, and another in the early 2000s after a string of accounting scandals rocked the US. Excluding international equities precludes your portfolio from taking advantage of these periods of international outperformance.
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
International equities are too big to ignore
MSCI ACWI geographic weights
The bottom line
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