Does Global Diversification Work?
When you choose stocks for your portfolio are you guilty of what many investors refer to as a home-country bias? This type of bias causes one to allocate a greater weight to US stocks than their percentage (about 42%) of total global market capitalization. If you answered yes to this question, you are not alone. Recent estimates suggest that US investors are over-invested at home with an allocation of over 65% of their stock positions to US companies. The rationale for this over-investment can range from simplicity to familiarity to perceived safety. That all sounds ok. However, if our goal is to produce higher risk-adjusted returns we must diversify globally with the view that many good stock investment opportunities await us overseas.
To see how diversification can improve our portfolios, we must first understand the concept of correlation. As defined, “correlation is a measure of how prices of two types of investments move in relation to each other.” When two assets are perfectly correlated (correlation of +1.00), their price movements are in the same direction (gain or loss) in reaction to different market forces. A perfectly negative correlation (-1.00) between investments indicates that their prices move in opposite directions in response to those same forces. Over the long run (say a 20-year period) the correlation between US large cap stocks (S&P 500) and international stocks (Europe, Australia, Asia and Far East) is about 0.58, which tells us that the price movement of US stocks and international stocks is synchronized just 58% of the time. This independent movement of global markets, which react to factors such as different monetary, fiscal and economic growth cycles, has historically provided significant diversification benefits when international stocks are held in combination with US stocks.
To better visualize how a combination of US and international stocks might work, let’s look at data over the last 50 years (1973 – 2022). During that period, US stocks outperformed international stocks in just 26 out of 50 years. The period average return for US stocks was +10.53%, while international stocks returned +7.98%. But, there is more to this story. The longest streak of US stock outperformance was four years (1995 - 1998) during which time US stocks returned +30.62%, while international stocks returned +9.77%. In contrast, in six consecutive years (2002 - 2007), international stocks performed better (+15.67%) than US stocks (+7.28%). We are currently 12 years (US stocks beating international in 9 of 12 years) into the current cycle of US stock outperformance. Our stock selection decisions (US or international) over the long term may very well have been different than those made on a cyclical basis. Diversification is the tool we need when faced with the difficulty of predicting which market (US or international) will be a top performer in any given year or period of time.
Over the long term, the benefits of global diversification are clear. However, during short term events like the 2008 financial crisis and the 2020 Covid sell-off, correlations of risky assets (stocks) tend to rise and converge at or near +1.00. This means that in the worst of crises, there is no stock (US or international) that is safe from loss. This short term failure of diversification (due to the converging correlation of risky asset pricing) should not blind us to its demonstrated benefits over a long investing horizon. It is over a longer time horizon that stock price performance will be more directly related to underlying economic growth (both here in the US and abroad) rather than short term periods of market selloffs marked by increased volatility and investor uncertainty.