When Stocks Are at All-Time Highs, It Is Time to Diversify Abroad

International Diversification Can Help Lower Risk, Improve Returns

The average investor has about 85 percent exposure to United States equities despite the fact that they account for less than half of global market capitalization. This phenomenon, known as the home-country bias, can be costly over the long-term. While U.S. equities have been strong performers, higher price-earnings and price-book ratios tend to lead to lower 10-year returns and a greater likelihood of draw downs and international stocks can help smooth returns.

Investors may want to consider increasing their international exposure, particularly when the domestic stock market is trading at a high price-earnings ratio.

Why Invest in Foreign Markets?

Many investors only look at total returns when evaluating different investments. For example, you may compare two mutual funds based on how they performed over the past 1-, 5-, and 10-year periods and select the best performing fund for their portfolio.

The problem with this approach is that it ignores risk. For example, an investor’s 120 percent returns in a year may look great—until you see that they’re invested in penny stocks! The investor could experience an extremely poor year if it were to continue making these kinds of risky investments. You should instead look at risk-adjusted returns that take risk into account and ensure that your portfolio doesn’t experience extreme volatility.

According to Vanguard, investors with a 20 percent allocation to international equities had 70 percent of the maximum diversification benefit while those with a 30 percent allocation had 90 percent of the maximum diversification. There have also been several periods throughout history where international equities picked up the slack in the U.S. market, such as the mid-1980s, late-1970s, and early-2000s, improving total returns—not just risk.

Why Diversify When Stocks Are Lofty?

Vanguard found that price-earnings ratios have historically been one of the only meaningful indicators of long-term returns, explaining about 40 percent of future 10-year returns. Star Capital subsequently confirmed that this was also the case for at least 16 other international equity markets. Price-earnings ratios have an inverse or mean-reverting relationships with future stock market returns, which makes them helpful when analyzing potential opportunities.

The United States has traded at a modest premium to the rest of the world over the past decade, which is likely due to its strong governance, rule of law, and other factors. But, there are times when the U.S. market has traded at a significantly greater premium to global markets. During these times, investors may want to consider increasing their diversification into international investments to capitalize on the mean-reversion tendencies.

When analyzing price-earnings ratios, the cyclically adjusted P/E ratio—or CAPE ratio—is often considered to be the most accurate measure. The CAPE ratio measures earnings per share over a 10-year period to smooth out fluctuations in profits that occur over different periods of a business cycle. This produces a much more accurate measure of valuation multiples than using the price-earnings ratio at a specific point in time.

The Best Ways to Diversify Abroad

There are many different ways to diversify into international investments, but exchange-traded funds (ETFs) and mutual funds are the easiest options. In general, investors may want to consider these funds as a low-cost way to diversify compared to purchasing a portfolio of American Depositary Receipts (ADRs) or foreign stocks. It’s also important to choose funds with low expense ratios to maximize long-term returns.

Investors holding S&P 500 index funds may want to consider adding an international index fund to their portfolios. For example, the Vanguard FTSE All-World ex-US ETF (VEU) holds more than 1,000 different equities concentrated in Europe, Asia-Pacific, and Asia. The iShares Core MSCI Total International Stock ETF (IXUS) is another option that holds nearly 4,000 equities in the same regions with slightly greater exposure to North America (Canada).

Vanguard recommends that investors consider allocating 20 percent to 40 percent of their portfolios to international equities. The firm notes that these allocations should be based on the global market capitalization for international equities, which currently stands at about 50 percent. That is, if international equities grow to account for a greater share of total market capitalization, then you should increase their exposure to international equities.