A lot of investors have abandoned international diversification (or at least strongly considered it) in recent years.
I understand why this is happening.
The U.S. stock market has destroyed all comers ever since the Great Financial Crisis ended.
Since 2009, a total U.S. stock market index fund is up more than 660% while a total international index fund is up more like 180%. That’s annual returns of more than 14% per year in the U.S. versus less than 7% per year in the rest of the world.
There are good reasons for this performance gap — a bigger tech sector, a strong dollar, the U.S. economy has performed better, etc.
A lot of investors assume they don’t need to hold international stocks anymore because large U.S. corporations get a decent chunk of sales and earnings overseas, the U.S. is in a dominant position in the global stock market (making up roughly 60% of the overall market cap), a more favorable regulatory environment for innovation and the tech sector.
I get all of that. Considering how powerful our corporations and financial markets are, it seems foolish to invest outside of the United States.
Yet I still believe in international diversification.
Why?
There is no guarantee the U.S. stock market is going to replicate the success it has had over the past 15 years over the next 15 years.
While the U.S. stock market has been the clear winner for the past decade and a half, the winners tend to change from decade to decade.
Take a look at the total returns by decade1 for various developed economies going back to the 1970s:
Every decade has big winners and big losers. Just look at the spread between the best and worst performers in each period. There are some massive gaps.
U.S. domination could be a sign of a paradigm shift in global markets or it could be recency bias.
You don’t have to look too far back for a lost decade in U.S. stocks (it happened from 2000-2009). In the 1970s and 1980s, U.S. stocks were closer to the bottom of the pack than the top.
I like diversification as a form of risk management because it helps you avoid the extremes. Yes, that means you’ll never be fully invested in the best performer, but it also means you’ll never be fully exposed to the worst performer.
Diversification also opens you up to surprising winners too.
Legendary investor Peter Bernstein once said, “I view diversification not only as a survival strategy but as an aggressive strategy, because the next windfall might come from a surprising place.”
International diversification might not protect you against bad years or even bad cycles.
What it’s meant to do is protect you against terrible decades. Every country has them.
Even the United States.
Further Reading:
The Case For International Diversification
1I used MSCI country stocks market indexes for the foreign markets, which means these returns would be from the perspective of a U.S.-based investor, not in local currency terms. I used the S&P 500 for U.S. stocks.
