If any part of your portfolio has been exposed to the international capital markets over the past few years, you know that it has very handily under-performed an all domestic allocation. So why go global when an all domestic portfolio would have done a decent enough job. Two reasons – diversification and the potential to generate greater returns…OVER TIME.
US corporations represent about 50% of the global stock market capitalization with the other half and oftentimes faster growing companies found abroad.
Ignoring that much of capitalism outside our shores is foolish but that does not mean we go crazy and allocate say 50% of our investment dollars to the international stock and bond markets though capital markets theory would clearly espouse that. Studies have shown that equity allocation in the 30-40% range would be just optimal, enabling us to take advantage of lower correlations in performance between the domestic and international asset classes in our re-balancing efforts.
And to stress on that correlation thingy, US markets will not always outperform. Asset class returns rotate from time to time between different geographic regions and market capitalizations as shown in the table below.
A global portfolio historically has made us more money than a US only portfolio and there is no reason to believe that will not continue. The table below shows the growth in the value of $1000 if invested in US, Asia-Pacific and European regions by themselves as well as a global portfolio invested in all three regions in equal parts.
And then there is the relative valuation differences between US and international stocks. US-based stocks today are almost twice as expensive as stocks of companies based in other parts of the world. To some extent, that valuation difference is explained by the relative economic under-performance of other regions as compared to that of US but that could change and it will change with time. We want to be there before that happens. When of course don’t know when that will happen and we don’t care.
One last word on diversification…you are only truly diversified if you find some pieces of your portfolio under-performing others from time to time. A truly 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 risk optimization trade-off you have to live with. 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 the cycle of returns will change course and hence we have to remain invested.
So we don’t mind this temporary under-performance and so shouldn’t you.
Image credit – Pixabay