What follows is a hypothetical conversation between two fictitious investment experts, Bob Smith, who lives within the USA, and his colleague Sandra Mueller, who works in Frankfurt.
Her topic: international stock investments and diversification.
Bob Smith: Hello Sandra, how are you?
Sandra Mueller: Hello Bob. Good, thanks. Everything is tremendous here in Germany.
Last time we spoke, we began discussing international stock investing from a U.S. perspective. The world has definitely modified and continues to achieve this, and there are definitely pros and cons to contemplate, so I’ve done some research and evaluation that I’d wish to share with you.
Excellent. I’ve made some too.
What did you think that of?
So I checked out the S&P 500 for US stocks and the MSCI EAFE and Emerging Market (EM) indices. I selected these two as a substitute of the MSCI ACWI ex US to get a more nuanced view of the international scene. The time period I focused on is 1988 to 2020, which I feel covers quite a bit.
And what did you discover out?
Well, let’s start with returns. As everyone knows, the United States has done very well over the past decade. Before that, results were mixed, but in the long term, the S&P won the race, beating emerging markets and destroying the EAFE index.
The following graph shows the cumulative performance over the period.
Cumulative index performance
Yes, the S&P has had an ideal run while emerging markets and the EAFE have been stagnant over the past decade. In fact, the EAFE’s performance has been really disappointing for a very long time.
But return is just a part of the image, in order agreed, I analyzed risk and correlation. If international investing looks bad on a return basis, it gets even worse while you add risk into the equation. I calculated the usual deviations of returns for the Nineteen Nineties, 2000s, and 2010s and plotted them against the returns for the three indices.
This is what I got:
Annualized returns and standard deviations, Nineteen Nineties to 2010s
As you noted, the US has produced higher returns. But there has also been less risk. It’s a “win-win” as you say. And as we discussed last time, correlations have increased over time, limiting the advantages of diversification. Correlations were around 0.55 for EAFE and EM within the Nineteen Nineties, but have increased to around 0.85 for EAFE and 0.75 for EM over the past decade.
So is that this what is supposed when one speaks of “diworsification”?
Speaking of diversification, I’ve graphed the monthly returns of the three indices for the 33-year period. I feel when people discuss diversification, what they’re really talking about is that their foreign allocations protect them when U.S. returns are negative. So the graph below shows 396 months each for the S&P 500 and MSCI EAFE index on the one hand, and for the S&P 500 and MSCI EM index on the opposite.
I do not think anyone is especially concerned if each U.S. and foreign investments perform well, or even when one has a positive return and the opposite a negative one. I assume that is what diversification is all about. But if each investments perform poorly, it’s a special story.
Look on the “disappointment” quadrant within the chart below. Over the 33 years, the S&P had 143 losing months, or 36% of the overall. The EAFE index also lost in 55 of those months, and the EM index lost in 53. The average loss for the S&P was 3.5%, but the common for the EAFE index was 4.3% and the EM index was 4.5%, adding to investor disappointment.
S&P 500 vs. MSCI EAFE and MSCI EM, monthly performance, 1988 to 2020
Based on the facts, it’s fair to say that things are usually not looking good for investing outside the United States. Maybe you must leave all of your money at home, Bob.
I do know. That’s what you’ll think. Have you ever heard of “Acres of Diamonds,” the speech by Russell Conwell, founding father of Temple University? Conwell reminds us of a parable that teaches that there are many diamonds in your individual backyard and that you simply haven’t got to go far to potentially seek for them in vain. This seems to make sense given the big, world-famous technology corporations we now have here within the United States.
True. But remember: That’s all water under the bridge. We must all the time look to the longer term. And although the US accounts for nearly 60% of the world’s stock markets, there’s one other 40% on the market.
And the US only accounts for 1 / 4 of the world’s GDP and only 4% of the world’s population. In other parts of the world, growth is way higher and there’s quite a lot of innovation in artificial intelligence, electric vehicles and so forth. Don’t you ought to be an element of it?
I understand you. I assume we never know what’s going to occur. We should tend to take a position on a regular basis everywhere in the world and have no less than a small share within the international markets.
Exactly! The bottom line is that international, developed and emerging markets may offer lower returns with higher risk and better correlations, but as prudent investors we must consider in diversification because no person knows what the longer term holds.
Right! That’s great, Sandra. Thanks for all of your help. Let’s talk again soon. Take care.
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Photo credit: ©Getty Images/ Yuichiro Chino
