BUNK 44

WHO NEEDS FOREIGN?

Who needs foreign? You, probably. Maybe you’ve read Bunk 43 and know non-US stocks as a category shouldn’t be inherently more or less risky than US stocks and, long term, should net pretty similar returns. So if they aren’t more (or less) risky, and returns should be similar (long term), why bother? Two reasons:

1. Risk management

2. Return opportunities

Yes, in the very long term, US and non-US stocks should have very similar returns (and actually have had throughout well-measured history). But for many years at a crack—maybe three to seven, but sometimes more and sometimes less, one category can best the other—just like with all other categories like growth versus value, or big cap versus small cap, or Tech versus Energy. (Bunk 10.)

Figure 44.1 shows the S&P 500 performance divided by the MSCI EAFE Index. When the line is rising, US stocks are overall outperforming non-US (also shaded in gray). When the line is falling (white bars), non-US stocks are outperforming. You intuitively see that the white and gray, rising and falling, almost exactly equal each other. But for years at a crack they don’t.

US and Non-US Trade Leadership—Irregularly

Since 1970, US and non-US stocks have traded leadership irregularly for irregular periods. Sometimes US stocks outperform by a lot for a long time—like in the mid to late 1990s when they led EAFE by 193.5 percent.²

Figure 44.1 S&P 500 Versus MSCI EAFE—Sometimes US Leads, Sometimes US Lags

Source: Thomson Reuters, Global MSCI Inc.,¹ S&P 500 total return, MSCI EAFE total return with net dividends from 12/31/1969 to 12/31/2009.

And sometimes foreign is the winner—like in the 1980s, by a huge 241.1 percent.³ Sometimes outperformance periods are much shorter.

But over ultra-long periods, you tend to end up in the about same place—remember, since 1970 US stocks have annualized 10.0 percent, and EAFE 9.4 percent.⁴ (Bunk 10 covers why.) And don’t take this graph to mean they wildly flip-flop! No—they tend to go the same direction overall, but one might be up a bit more or less than the other, or down a bit more or less. (See the graph in Bunk 43 again.)

So you might feel great during the 1990s with an all-US portfolio, but you really missed out for much of the 1980s and big parts of the 2000s. And while you may have an opinion, which is fine, there’s no certain way to know which will lead going forward and for how long. So an all-US investor could easily get caught in another long period like the 1980s. Hypothesis: If foreign stocks aren’t inherently riskier, and you tend to get similar returns over long periods, with multi-year periods of leadership and laggardness, why miss out when one or the other is outperforming? Owning both stabilizes your return stream over the long term.

There are other performance opportunities investors miss when ignoring foreign. By investing globally, you have the whole wide world to choose from—a bigger choice set. If, in doing analysis, you develop conviction that foreign is likelier to outperform the US, you can overweight foreign. Not go whole hog and purge the US, but if foreign stocks are about half the world, you could increase your foreign holdings to 55 percent, 60 percent, or maybe 65 percent of your portfolio. If you’re right and foreign does better, you get a bit of a performance boost! If you’re wrong and foreign lags the US, you’re not hurt too badly because you’re still holding a big chunk of US stocks. And you can make the same portfolio tweaks for narrower categories—sectors, single nations, even size and style. But if you invest globally, you have more choices and chances to make portfolio tweaks that, if you’re right, can enhance performance. The best part is you needn’t be right all the time—just right more than wrong. That’s the performance-enhancing side.

Opportunities to Manage Risk

Investing globally means more risk management opportunities too. The very fundamental nature of modern portfolio theory says diversification—the blending of categories with differing correlations (things that zig when others zag)—lowers total portfolio volatility risk. And the broader you diversify (done right), the more benefit you get.

Why? The broader you invest, the more you diversify away sector, size, style, and single-country risk. Can you still experience downside volatility? Of course! Tons of it! No equity index in the universe (should we have a universal index one day) can diversify away market risk. But can it smooth the bumps a bit and be more of a cushion than a narrower index? Yes—finance theory says so.

Why do US and foreign and all these other categories end up with very similar long-term returns? Read Bunk 10! And don’t give away chances to enhance performance and manage risk. It’s so easy—just be global.