Avoiding The Recency Bias in Foreign Stock Markets

“International diversification might not protect you from terrible days, months, or even years, but over longer horizons (which should be more important to investors) where underlying economic growth matters more to returns than short-lived panics, it protects you quite well.” – Cliff Asness

I’m probably belaboring the point on global diversification, but I think it makes sense to revisit these types of important topics to offset the recency bias of assuming the future will play out exactly like the recent past.

Markets are in a constant state of change and above all else, they are cyclical. See the rolling three year outperformance of the S&P 500 over the MSCI EAFE since 1970 for proof:


Any time that line dips below 0% that means foreign stocks were outperforming on a total return basis over the previous three years. This shows that U.S. stocks are outperforming international stocks by more than 50% over the last three years.

The over- and underperformance can get to extreme levels (yes, that’s over 250% of outperformance for international stocks in the late-1980s) for both U.S. and international markets, but there were also some fairly quick reversals as well.

Looking at the annual returns by decade for each shows how out of sync the developed markets can become over longer periods:


Globalization was supposed to increase the correlation between the different stock markets around the world, but it just doesn’t seem to be happening quite yet. We are still seeing periods of divergent performance.

It very well may turn out that having a larger exposure to U.S. stocks will continue to be the right move for the next few years. These trends can last longer than many think. But even if a long-term cycle of outperformance continues, over shorter time frames the results can still prove to be uneven. Take a look at the winning percentage of annual returns by decade for the EAFE and S&P 500:


While foreign stocks slaughtered U.S. stocks in the 70s and 80s, they only outperformed six out of every ten years. Even when U.S. stocks came back with a vengeance in the 1990s, foreign stocks outperformed three out of the ten years, which abruptly reversed over the following decade.

This type of back and forth leadership is actually a good thing for a diversified portfolio because it allows an investor to rebalance from the relatively strong market to the relatively weak market. Even those decades with severe underperformance allow investors to take advantage of shorter-term outperformance by the laggards in any given year.

A balanced portfolio is always going to have an asset class or two that’s out of sync with the winner(s) in the portfolio. That’s the trade-off for managing risk. The mistake most investors make is abandoning diversification right before they need it the most. Unfortunately, the markets don’t run on a set schedule to tell us when those regime changes will take place.

Further reading:
Global diversification: Accepting good enough to avoid terrible
How diversification works

Now for the stuff I’ve been reading lately:

  • Investment lessons from the poker table (Vitaliy Katsenelson)
  • Investor behavior > Investment behavior (Irrelevant Investor)
  • Charley Ellis: Risk matters (Wealthfront)
  • The wall of worry, illustrated (Bason)
  • Charlie Munger’s advice to Bob Rodriguez 30 years ago (Valuewalk)
  • Vanguard’s impressive performance record (Reformed Broker)
  • A perfect example of the behavior gap at work (Abnormal Returns)
  • Markets are one big cycle of long-term stability followed by short-term instability (Crossing Wall Street)
  • Not everyone sucks at investing (Philosophical Economics)
  • There’s no such thing as an intermediate-term investor (Brian Lund)
  • Happiness is somewhere between having too much and having too little (Prag Cap)
  • What if you only invested in the 5 best performing country stock markets from the previous year? (Novel Investor)
  • Barry Ritholtz on Tony Robbins’ skills as a financial guru (Big Picture)
  • How your Shazam app is deciding the music industry (Atlantic)

Subscribe to receive email updates and my monthly newsletter by clicking here.

Follow me on Twitter: @awealthofcs

What's been said:

Discussions found on the web
  1. Jason @ Islands of Investing commented on Nov 21

    Fascinating how extreme the variance in performance can be between the US and foreign stocks. I’m considering branching out and getting some more international exposure, as my portfolio is 100% Australian stocks, although many of these businesses have some international exposure.

  2. Jim Haygood commented on Nov 21

    A substantial portion of divergences between US and foreign stocks is driven by currency moves. For instance, the huge underperformance of US stocks vs the EAFE in the late 1980s paralleled the dollar’s decline after the 1985 Plaza Accord, as can be seen by comparing the dollar index during that period:


    Mixing currency speculation with stock investment is a recipe for unpleasant surprises. But to the extent that momentum works in currencies as it does in stocks, one can effectively kick in some turbocharger boost by riding simultaneous stock and currency uptrends.

    Gary Antonacci’s new book, Dual Momentum Investing, discloses a simple system which, using only US equity, EAFE and bond funds, returned about 17% since 1974.

    • Ben commented on Nov 21

      This is a great point and one that (surprisingly) gets very little attention. I have a post I’m working on about this subject.

      I agree that currency speculation is a tough game. It’s crazy that those mkts are open 24 hrs a day, but like your graph shows they do tend to move in long cycles.

      The majority of the underperformance in the EAFE this yr comes from the foreign exchange.

  3. Clark G commented on Nov 25

    Great writeup Ben. We preach the same benefits of diversification to our clients as well. Although many investors have a bias to the S&P and recent trends like we’re seeing of outperformance make some of them wonder about the reason for being diversified. When they see charts like these spread out over longer periods it paints a much clearer picture for them.

    • Ben commented on Nov 25

      Thanks Clark. It seems like these kinds of reminders are needed anytime we get to these kinds of extreme points in any given cycle. Really tough to remember in the short-term, but reversion to the mean is one of the few things you can count in in the financial markets. Just takes some time.

  4. Our Top 4 Must Reads from November - Financial Symmetry, Inc. commented on Dec 05

    […] Avoiding the Recency Bias in Foreign Stock Markets – We’re all prone to thinking we are best suited by having more of our investments in the areas that have performed the best over the last year. Just take a look at the historical returns on your investment reviews and see which ones initiate a positive feeling in your gut. This article, in unison with our special market commentary last month, stresses the point that we shouldn’t assume the future will play out exactly like the recent past. As the author points out, the most common mistake is “abandoning diversification right before [we] need it most.” […]