My December article for Physician's Money Digest was titled “Don't Give Up On International Stocks.” I wrote in response to a trend I've been seeing lately with new asset allocations/portfolios where the percentage allocated to international stocks seems to keep getting lower and lower. It really smacks of performance chasing. As of December 22, 2016, the US Stock Market is up 13.6% year-to-date while the International Stock Market is only up 3.9%. In fact, that has been the case for the last four years, as described below:
- 2013: 16.4% vs. 15.1%
- 2014: 12.6% vs. -4.2%
- 2015: 0.4% vs. -4.3%
- 2016: 13.6% vs. 3.9%
Therefore, it is no surprise, to me, to see more and more investors, particularly new investors designing their portfolio for the first time, decreasing or even eliminating international stock holdings in their portfolios. While my crystal ball is just as cloudy as everyone else’s, this is likely to be a mistake. To understand why, let’s first take a look at the historical record.
The record for the last 20 years is probably best displayed with the Callan Periodic Table of Investment Returns. This table ranks the various major asset classes by performance for each year in a handy, color-coded table. The three boxes I’d like to concentrate on are the S&P 500 (brown, representing the US Stock Market), the MSCI EAFE (grey, representing the non-US Developed Countries Stock Market), and the MSCI Emerging Markets (orange, representing the Emerging Markets Stock Market). As you will notice, US Stocks have outperformed Developed Market Stocks in 11 of the last 20 years, including five of the last six, (six of the last seven if you include 2016). US Stocks have outperformed Emerging Market Stocks in nine of the last 20 years, including the last three years (last four if you include 2016). It is also notable that when it comes to comparing returns, Emerging Market Stocks are frequently either the best or the worst (eight out of 20 the best, and seven out of 20 the worst).
What does all that mean? It means that historically, international stocks beat US stocks about half the time and that if you wait long enough, each asset class will have its day in the sun. The problem with diversification is that it works even when you don’t want it to. However, the longer an asset class has been out of favor, the more attractive its valuations become and the better its future prospects are. That means that you can buy a larger part of a company, its profits, and its future performance for the same price. This can be most easily demonstrated by looking at the yields of mutual funds that invest in each of these types of stocks.
- US Stocks: 1.8%
- Developed Markets Stocks: 2.9%
- Emerging Markets Stocks: 2.5%
The valuation difference can also be seen using the classic measurement of the Price to Earnings Ratio:
- US Stocks: 19.7
- Developed Market Stocks: 15.7
- Emerging Markets Stocks: 13.5
That means that in order to get the same $1 of earnings from a company in the US, you would have to pay 45% more than in an emerging market and 25% more than in a developing market.
Valuations, just like past performance, are no guarantee of future performance, and there are some good reasons why international stocks, particularly in emerging market countries, often have higher yields and lower P/E ratios than US Stocks. The US is a great country and an economic powerhouse with an excellent entrepreneurial climate, strong investor protections, and a highly educated and productive workforce. As measured by Gross Domestic Product, the US still has the largest economy of any country in the world, including China with over four times as many people. The US economy is about the same size as all of Europe, despite having less than two-thirds of the population. Certainly it makes sense for an investor, particularly a US investor, to keep a large percentage of the public equity portion of his/her portfolio invested in US stocks. But increasing the percentage of the portfolio in US stocks AFTER they have performed well in the recent past, smacks of performance chasing and recency bias, which often lead to poor investing returns.
Most stock investors have an investing horizon of many decades, especially when you consider the amount of time they will be investing in retirement. The likelihood of US stocks continuing to substantially outperform international stocks continuously over that time period as they have over the last half decade seems quite low, especially when considering the benefits of diversifying the portfolio across additional dozens of national economies and additional thousands of companies. In fact, a large percentage of the difference between US stocks and international stocks can be attributed to a single factor—a strengthened dollar. In 2008, a Euro cost $1.60. Today it costs $1.04. It isn’t that international companies like Nestle, Samsung, and Toyota aren’t generating solid profits, it is that we are pricing their stocks in US dollars. That driving force, a strengthening US dollar, can be shown to swing back and forth like a pendulum over the decades. If the future resembles the past, even vaguely, it is likely that trend will reverse at some point in the next 10 to 15 years, and maybe a lot sooner.
So what is an investor to do? Just two things. First, recognize that international stocks are solid investments worthy of her investing dollars, despite the fact that many US companies receive significant revenue from other countries. Allocating a reasonable portion of a public equity portfolio to international stocks adds valuable diversification. Most experts agree that a reasonable portion is somewhere between 20% and 50% of stocks. Ignoring half of the publicly traded companies in the world when designing your portfolio is likely an error.
Second, STICK WITH YOUR PERCENTAGE. It turns out it doesn’t matter all that much in the long run whether you allocate 20% or 50% or anything in between. Each asset class will have its day in the sun. When US stocks do well, you will regret whatever percentage you have put into international stocks. When international stocks outperform, you will wish you had allocated more into that asset class. Likewise with a strengthening or weakening dollar. Changing your portfolio in response to recent performance, either good or bad, or currency changes is a recipe for investing disaster. When designing your portfolio write down each asset class you wish to invest in, assign a fixed percentage of the portfolio you will allocate to that asset class, and describe the reason why. Then, when you have doubts due to recent underperformance, you can revisit this written investing policy statement to help you to stay the course, which is the real key to investing success. Sticking with any reasonable plan is better than frequently changing from one plan to another that might seem marginally better at the time.
Do you invest in international stocks? Why or why not? What percentage of your portfolio is allocated to them? Has that changed in the last 10 years? Why or why not? Comment below!
Admittedly, I have also been tempted to decrease the percentage of international stocks in my portfolio. This article reminds me of the importance of developing a fixed asset allocation and staying the course. In the words of Collin Raye, the attitude with an investing plan needs to be “That’s my story and I’m sticking to it.” https://www.youtube.com/watch?v=BewKY_BpVXg
Good article, White Coat Investor. Great reminder of why I’m 15% in Vanguard’s Developed Markets index and 10% in Vanguard’s Emerging Market index… and why I need to continue.
Just getting started with our nest egg over the past year, but we have 25% of our portfolio in international with Vanguard Total International Admiral Shares (VTIAX) at the moment. Might consider doing a tilt to emerging markets, what’s the general consensus about how much one could allocate of their total international exposure to emerging markets for young investors in the accumulation phase (I’m turning 30 this month)?
Remember that a good chunk of Total International is in Emerging Markets. Not sure the current percentage, but it’s usually in the 20% range. So if you want to own more than that I wouldn’t own much more. Maybe 5% more.
Morningstar is great to see breakdown of developed versus emerging markets. http://portfolios.morningstar.com/fund/summary?t=VTIAX®ion=usa&culture=en_US
look under portfolio and scroll to the bottom. 15% emerging markets in VTIAX
It’s interesting seeing the many comments on Bogleheads in recent years to the tune of “Should I invest in US Stocks since they are at an all time high?” adjacent to topics that say “Why International?”.
You’d think that the same people who are hesitant to invest in something that has done so well recently would be very inclined to invest in a class that has recently underperformed.
well this is one of those issues I’m guilty of. I haven’t actually sold any international, just not put new contributions toward it in a while (rationalization on my part especially since the truth is that I haven’t sold any of my index funds/etfs). I also really haven’t adequately reviewed the data on what is closer to a 2 fund portfolio vs a 3 fund. When I place contributions in later this year, I really need to think more about this.
Well said. The strength of the US dollar and recent gains in the US markets do make one feel good about holding US equity. That’s the beauty of having a diversified portfolio and rebalancing on a fixed schedule — it forces you to buy low. That never feels good but it is the right thing to do.
It’s amazing how hard wired we are to do the wrong thing when it comes to investing. Set a reasonable allocation and stick to it through thick and thin. Consistency is the key to good returns.
And, completely off topic, the CAPTCHA asked me to select pictures of dining rooms. Kind of funny given WCI’s history.
Great post and emphasizes the importance of having a plan and sticking with it. That allocation and rebalancing really automated buying low and (if selling), selling high. Only reason I put all of our backdoor Roth contributions this year into international as my equity portion was now over represented by domestic stocks due to their recent performance
I’m currently reading “The Four Pillars of Investing,” and this is exactly what Bernstein talks about. Investors who don’t stick to a written investment plan typically buy funds that have been doing well recently. A fund that has done well recently is more likely to have lower future returns, while a fund with poor recent performance is likely to have higher future returns. People who are buying up S&P funds now and not international funds are setting themselves up to buy high, sell low, and minimize future returns.
I think this is gambler’s fallacy. If that were true, it’d be pretty easy to time the market.
This was the topic that made me start thinking of ditching my advisor…When I went in for a regular checkup and he suggested that we move out of my international funds because they under-performed my US funds…I replied with, “shouldn’t I be putting MORE money into the international now?” “No, international has under-performed.” The conversation ended with the suggestion that I buy US funds high and sell International low…and with me finding WCI..and no, I did not follow the suggestion!
Like Buffett says, “Be greedy when others are fearful.” I’m simply maintaining my allocation of 10% of my portfolio each to developed and emerging markets. Perhaps I’m not being greedy, but I’m not buying into the fear, either.
It’s interesting to view the CAPE (cyclically adjusted price : earnings) map of the world. The US trails only Ireland and Denmark, each of which have a cape above 30. Meanwhile, Brazil, Russia, and Emerging Europe are trading at a CAPE under 10. There are geopolitical reasons for some of the discrepancy, of course, but that is quite a gap. Map: http://www.starcapital.de/research/stockmarketvaluation
Best,
-PoF
But that means investing in Russia
“It really smacks of performance chasing.”
and then…
“let’s first take a look at the historical record….”
Sounds like the editor is out history chasing? 😉
It is good to see this post considering some advocation for a single S & P index fund strategy which is being stated on some websites. I keep most of my money in US stocks, but a small portion in International (approximately 10% of my assets).
-EJ
Now that so many ‘US’ stocks are multinationals which derive a large percentage of their revenue from international markets, does that change the calculus of the need for ‘international’ exposure as a distinct component of an individual’s portfolio? Rules of thumb are nice, but has globalization made this one of less import? For example, in 2014, the component of the S&P 500 booked 47.8% of their revenue from outside the US…seems like an investor gets a lot of international exposure from an S&P 500 index fund alone.
Thoughts?
Would love people’s comments on these points of views regarding international stocks –
http://jlcollinsnh.com/2012/09/26/stocks-part-xi-international-funds-2/
and bogle’s view
http://finance.yahoo.com/news/youll-badly-defeated-jack-bogle-220134837.html
As for where to invest, Bogle advises sticking with U.S. stocks over international equities.
While foreign stocks may be cheaper, they are riskier, he said. Plus, U.S. companies are really international companies, since half their profits come from outside the country.
“I’d rather bet on the U.S.,” he said. “This is a great nation with great places to invest. Great financial institutions, great government institutions, although a little bit faltering.”
For those who do want to add international exposure to their portfolio, he wouldn’t invest more than 20 percent.
It’s more important to stick with your percentage than what percentage you actually choose. Personally, I think it’s silly to ignore more than half of the publicly traded companies in the world. Imagine you were a Japanese investor in 1988-1990 and you just decided to invest your whole wad in Japanese stocks only.
I’m not sure comparing US equities to Japanese equities is an accurate comparison. But agree that you should stick to your asset allocation. Just wanted to spur discussion on an asset allocation of 0% international stocks given by others on this topic.
US equities make up nearly half of global equities, so you’re already pretty diversified. I’m not against investing in other markets, but it’s not like putting 90% of your assets in emerging markets.
Bogle agrees with this line of thinking, so you are in good company!
And Buffett.
“Ignoring half of the publicly traded companies in the world when designing your portfolio is likely an error. – “
How much are you paying for those earnings? Companies in those geographies compete with those S&P 500 companies and you can get their earnings from those same markets much cheaper. Note that US profit margins are at all time highs and profit margins at international companies are mostly below long term averages. The market works with high profits inviting more competition and low ones driving changes to increase them. The evidence is in the fact that profit margins are one of the strongest mean-reverting data series out there. I’d rather buy the low cost earning stream that is likely to increase over time than the expensive one at all-time highs that is likely to decline over time. The price you pay is why the S&P 500 and local foreign investment are not the same.
Many international stocks get a significant part of their revenue from inside the US. Seems like an international investor gets plenty of US exposure from a Total International Stock Market fund alone.
Does reversing your argument help you see why that’s a less than ideal approach?
Thanks, I needed the support. I haven’t changed anything but have been thinking about it. True story: about 15 mins before I read this, a colleague asked me for help with his portfolio allocation. I told him my allocation and put the caveat that our developed markets vanguard index fund has been underwhelming for some time now. I just need to remember that I have no idea what’s going to happen.
International stocks are currently a heck of a deal, especially large cap developed markets. ZC above commented: “Now that so many ‘US’ stocks are multinationals which derive a large percentage of their revenue from international markets, does that change the calculus of the need for ‘international’ exposure as a distinct component of an individual’s portfolio?” It’s correct that these large caps in the developed world have overlaps with large caps in the US. And yet we as a whole are discounting their earnings significantly compared to their S&P500 peers. Its essentially becoming a value play. I haven’t increased my preferred allocation for internationals as I realize the market can stay irrational longer then you can stay solvent, but if I were a market timer I’d be running towards this sector not away.
I have very little in U.S. stocks, but did purchase some VGK recently.
Valuing the market is not timing the market. The US may outperform over the next 1-, 3-, or 5-year period, but the longer the horizon, the more likely it is to underperform. This is because of the valuation discrepancy.
Nevertheless, I don’t expect a stellar return from any of my current investments (registration might be required): https://www.gmo.com/docs/default-source/research-and-commentary/strategies/asset-class-forecasts/gmo-7-year-asset-class-forecast-(nov2016).pdf?sfvrsn=2.
My allocation for international stocks these past years have been roughly 25% but as I was checking my portfolio this year to rebalance.. I was right at about 10% mainly due to significant contributions in my employer tax deferred which unfortunately has had limited inexpensive US index mutual funds and EXPENSIVE international funds. Right or wrong.. I had to rebalance using my wife’s tax deferred accounts but also some taxable and roth accounts? I have to say it was hard selling off some of the good high yielding funds to rebalance into less performing international funds.. but we’re back 25%! Its done… I put it away… and I will not look at it for another year.
It’s easy to accept the “stick to your AA no matter what” argument for the experienced investor that frequents these forums, after you’ve been through a few corrections and solidified opinions.
The tricky part is deciding exactly WHAT AA to pick as a starting point, a decision that often gets made early in one’s investment career, when green and naive.
Then one questions every “improvement” as we become more financially literate as ?a true improvement based on solid academic data and personal long term conviction or just recency bias and rationalization?
How many out there have stuck with a suboptimal portfolio because they realize sticking to the plan is probably better than tweaking even if for the right reasons?
It’s can be maddening.
Not long ago, when I was a know-nothing, I picked 30% of stock allocation to international. I make myself stick with 30% even though I’m tempted to go to 40%, though I do cheat and drift up in international small cap and emerging markets each year.
Absolutely!
How do I know I was right so many years ago?
How do I know if my gut is really just a whim?
Econ 101, Finance 101 tell you that you can’t focus on sunk costs or hold onto losses expecting them to bounce back. Why throw good money after bad?
Now you know why staying the course is hard.
If you’re making asset allocation changes, even tiny ones, more often than once every 5 years you’re probably doing more damage than good.
True. WCI, I seem to recall on an article detailing your own AA, you were tempted to ditch your Bridgeway microcap fund and VG large value fund, for the sake of “simplification”. Did you ever follow through? Bet you’re glad if you decided to stay put after 2016 rebounds.
Stay tuned. But yes, I caught the 2016 rebounds.
I find it helpful if you hide your allocations from yourself. I set up my rebalancing spreadsheet years ago and it doesn’t show my allocations on the page I use to rebalance each year. I just plug in my current values and it tells me how much of each fund to buy and sell. At this point, I don’t recall exactly what my allocations are, so it’s hard to get tied up in knots over whether I should shift them 5 or 10 percent. That’s probably a good thing for both my mental and financial health. (Although I have to admit that I do, at this moment, have a ballpark idea of where my allocations stand since I just saw my account values when I did my annual hour of financial management last week — rebalancing, backdoor Roth contribution, annual net-worth calculation and progress review with my wife.)
I’m a heretic and will use valuations to change my allocation when valuations have shifted too much. Usually I stick with a fixed allocation but early this year I went from 60% US stocks and 20% emerging markets in my portfolio to 20% US stocks and 60% emerging markets.
It seems like a crazy and massive shift but I detailed my rationale in a recent post. In short, the US market has gone up tremendously in the last 5 (and especially the last 3) years and emerging markets have done terribly and there are many macro reasons to believe things will shift back towards the mean over the next 10 years. I have no idea what markets will do in the next few years so I agree with the conventional wisdom that this type of market timing is foolish. But when valuation extremes happen, the probability of good long-term returns (10 years or more) changes between asset classes enough for me to take action.
Of course there are no guarantees but there is enough history that I feel comfortable making some bets. Note that I have several methods of risk mitigation and a good financial cushion so I can take some risk and not be ruined if things go wrong. However, I see a bigger long-term risk in holding too much of my portfolio in expensive investments (US) right now.
Let us know how that works out for you. So far it looks like it is working out poorly, no?
Hi, Jim. I’ve been following you for about a year now. First time posting. Love the work you do. Love your book. Thanks so much.
I wanted to add that I also have about 40% emerging, 40% developed, 20% US right now. I have a tactical assest allocation that divides the world up equally if the CAPE ratio is within 1 standard deviation of its long term average (Bernstein-esque), but over or under invests if above or below 1 standard deviation. I think value really does matter most when you have a long time frame and if you can stomach the volatility and stick to your plan.
I’m curious if you’ve read any of Meb Faber’s work. His research on global value is very interesting. Here’s a link to check out. He talks about something different than what I mention above, but I think the article emphasizes the point that investing in undervalued markets is a key driver of long term returns, even if the markets are thought to be far less stable and reliable than the US. Thanks.
http://mebfaber.com/2016/12/02/missed-780-gains-using-cape-ratio-thats-good-thing/
There is no doubt that if you buy something at a better price and the price eventually reverts to the mean, that you will come out ahead. But I think trying to beat a static asset allocation using valuations is a difficult task, particularly due to behavioral aspects.
Agreed about then behavioral aspect. Anytime you put a factor tilt on your entire portfolio you’d better be ready for up to a decade of relative underperformance (which I hope that I am!).
You should read Philosophical Economics breakdown of CAPE and its flaws, it will help you in seeing which actual “cheap” country is really cheap and which is a value trap. Combine that and looking at margins and return by sector (say tech vs. basic material weighting) will go a long ways toward making an even better decision.
What are your macro reasonings? In the macro world I see a super strong dollar with the threat from Trump of an even stronger one that would crush EM, but wouldnt be very good for US overall either but better than for EM. Also, EM and even other developed markets are far more heavily weighted in industries with lower margin businesses like basic materials and industrials as opposed to the US with tech, finance, etc…that are our largest allocations and high margin businesses, ie, there is a very good reason our stocks are valued higher and actually return more.
Yes, you could bet on a change, and I certainly had a nice swing trade in EM last year, but until policy is up for a vote, etc…you really dont know for sure whether the macro is in your favor. If you dont care about near term performance it doesnt matter as of course its likely to shift into your favor sometime intermediate.
Great article. I know better but the great performance of small value in 2016 still had me thinking about increasing my allocation there. My brain trying to overrule my gut that wants to chase performance. This article came at the right time.
About 40% of my equities are outside of the U.S. That has stayed pretty stable over 20 years or so. I don’t see a reason to change it now. There may not be an ideal exact number or percent but it may be between 20-50% from the finance literature I have read (AKA Efficient Frontier, CAPM, etc.)
I haven’t been too bullish about the International Stocks over the past few years even though logic tells us that we should when it’s not growing too much.
That being said, my inaction is more that my tax-deferred/tax-advantaged accounts don’t have enough room to contribute more. Bad excuse to try to avoid tax drag on the expense ratios. I’ll try to be more proactive in 2017!
“my inaction ….enough room to contribute more…” ?
You could shift some of your domestic equities into international within your tax-deferred accounts. Right?
Absolutely. Waiting for my 2017 Roth funds to settle so that I could contribute towards international. It’ll move me slightly closer to my intended allocation. However, due to the nature of my employer, most of my investments are still in taxable accounts.
When looking at your current allocations, do you guys also include the amount of CASH you have in your savings/checking accounts overall or only retirement accounts?
I look at it both ways. When I was younger I found it helpful to think of the emergency fund/savings/checking accounts separately from retirement. As I get closer to retirement, I realize it is really just one big pot. Look at it the way it makes the most sense to you.
I consider my extra cash and house equity as part of my bond portfolio.
I don’t have cash in my retirement AA, but when I look at any AA I only count the accounts that are dedicated to one particular goal. So one AA for retirement, one for college, one for an emergency fund etc. So since checking and saving have different purposes than retirement, I wouldn’t count them in my retirement AA.
I’ll add that I too have fallen into the trap of just adding to my SCHB (schwab broad market fund) which is mostly US and have not being adding to my international fund (SCHF). I invest about 8K monthly in my taxable and I know I should be adding to get my international back up to 20%. It’ s currently at about 11% and hopefully this article and comments will help me put my investment in my international fund on Feb 1st.
Ahhh…yet another advantage of the Target Fund. I just buy them and let them sit. No tinkering, no market timing. They just sit there and grow at their own pace. Buy it and take a nap.
agree strongly.
But that doesn’t allow you to maximize the tax efficiency of asset location, particularly if you have significant holdings in a taxable account.