Leaving home: International diversification
One predictable aspect of the global financial markets is their perennial volatility. But the historical pattern has been that when one asset class is underperforming, another could be in favor. The reverse can then be true within another few years. This is true despite an increasingly intertwined global community. International investment returns often move in different directions.
The cyclical nature of investing broadly across asset classes means long-term exposure to international assets may be a necessary staple in a portfolio to make the most of diversification, particularly now as the markets grow in complexity.
Rarely will investors find an asset class that provides consistently high performance. To help offset the risk of market volatility, diversifying internationally can be useful to mitigate risk and improve yield. However, international portfolio diversification is not as pervasive as it could be, or as some might assume. Home bias, a well-documented investor behavioral bias, has kept many investors from seeking to diversify abroad.
Take, for instance, the equity portfolios of U.S. investors. The U.S. represents less than half of the total value of 47 markets included in the MSCI All Country World Index. But more than 80% of U.S. investors only hold American stocks, according to Morningstar.
Going abroad for the long term
International investing can help guard against the risks of a portfolio that is overly concentrated in an investor’s home country.
International stock exposure, for instance, has historically lowered portfolio risk and improved risk-adjusted returns over the long term.
Exposure to international stock has historically helped improve long-term risk-adjusted returns
Source: Morningstar Direct, February 2018.
Note: A higher Sharpe ratio indicates better risk-adjusted returns.
*Sample portfolio comprised of the S&P 500 index (70%) and the MSCI EAFE index (30%) 1/1/1971 – 12/31/2017. For illustrative purposes only. Past performance is not indicative of future results. Not representative of any ASI products.
Portfolios that have a diverse mix of domestic and foreign assets are more likely to be able to weather various periods of market ups and downs in one particular market. This can create more stable, long-term portfolios. U.S. stocks outperformed international equities by 102 percentage points over the three years ended December 1997. It was a strong time to be invested in U.S. equities. But then after the “tech bubble” burst, when there was a sell-off in the stock market, and over the three-year period ended April 2006, international equities then outperformed U.S. equities by 64 percentage points. In other words, outperformance in one market seldom lasts more than a few years. An internationally diverse portfolio can smooth out portfolio returns over the long term.
The U.S. and Western Europe once represented the world’s leading economies. While they remain among the stronger developed markets, their present growth is relatively stagnant in these regions compared with other faster-growing and emerging economies such as those across Asia.
Emerging market and developing economies currently account for about 59% of the world’s share of gross domestic product (GDP), according to the International Monetary Fund (IMF).
Though there are benefits to investing internationally, investors may have preferred to stay focused within their own nations’ markets because it can be a challenge to distinguish among opportunities in unfamiliar markets.
Pursuing actively managed investment strategies are a potential solution, as they are created and monitored by managers with a thorough understanding of recognizing the potential opportunities across a wide universe of local markets. In addition, active strategies can provide access to a wider investment universe compared to what is represented by many benchmarks.
The actual percentage of how much investors have allocated to domestic compared to international assets should depend on long-term goals and risk tolerances. Investing in foreign markets, particularly emerging ones, often have the potential to be more volatile and carry higher risks.
For example, Morningstar’s Lifetime Allocation Indexes recommend a 20% foreign fixed income exposure for aggressive investors with longer time horizons, and that percentage fluctuates depending on time horizon and strategy. The same allocation index suggests between a 21% to 40% allocation of equity assets to international equities.
Whatever the percentage, investors who are under-allocated to international assets may be missing out on the chance for meaningful potential diversification and returns.
Diversification does not ensure a profit or protect against a loss in a declining market.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
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