Most people in the U.S. who invest have about 85 percent exposure to U.S. equities. This is in spite of the fact that they account for less than half of the global market capitalization. This phenomenon is known as the home-country bias. It makes sense why you would lean towards buying stocks and bonds in your own country, but the practice 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 chance of drawdowns. International stocks can help smooth returns.
As you invest, you may want to think about increasing your international exposure. This advice makes the most sense 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 they are deciding how to invest their money. For example, you may compare two mutual funds based on how they performed over the past 1-, 5-, and 10-year spans and select the best performing fund for your portfolio.
The problem with this approach is that it ignores risk. For example, if you have 120 percent returns in a year, on paper this looks great. But if all this money is in penny stocks you're missing the big picture. With a setup like this, you could suffer a very poor year if you keep making risky choices. You should instead look at risk-adjusted returns that take risk into account. This can help ensure that your portfolio doesn’t suffer from extreme volatility.
According to Vanguard, investors with a 20% allocation to international equities had 85% percent of the maximum diversification benefit. Those who invest 30% or 40% abroad had up to 95%.
There have also been many times in history where international equities picked up the slack in the U.S. market. The mid-1980s, late-1970s, and early-2000s, are a few such times when total returns could improve, without as much risk.
Why Diversify When Stocks Are Lofty?
Vanguard found that over time, price-earnings ratios have been one of the only true indicators of long-term returns. They explain about 40% of future 10-year returns. Price-earnings ratios have an inverse or mean-reverting relationship with future stock market returns, which makes them a helpful metric to use when you assess new opportunities.
The U.S. has traded at a modest premium to the rest of the world over the past decade. This 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 much greater premium to global markets. During these times, you may want to think about increasing your diversification into international investments in order to capitalize on the mean-reversion aspects.
When analyzing price-earnings ratios, the cyclically adjusted P/E ratio—or CAPE ratio—is often deemed to be the most accurate measure. The CAPE ratio measures earnings per share over a 10-year period. The longer time frame smooths out minor changes in profits that occur at different times during a business cycle. This produces a much more accurate measure of valuation multiples than using the price-earnings ratio at a single point in time.
The Best Ways to Diversify Abroad
There are many ways to diversify into international investments, but exchange-traded funds (ETFs) and mutual funds are two of the easiest options. For the most part, you can use these types of funds as a low-cost way to diversify, as 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 your long-term returns.
Vanguard recommends that you should invest about 40% of your portfolios to international equities. Of course, your own situation is unique, so be sure to consult a financial advisor for personalized advice.
If you hold S&P 500 index funds, you may want to think about adding an international index fund to your portfolios. For example, the Vanguard FTSE All-World ex-US ETF (VEU) holds nearly 3,600 equities from all over the world, mainly in Europe, Asia-Pacific, and Asia. It is valued at over $54 billion. The iShares Core MSCI Total International Stock ETF (IXUS) is another option that holds over 4,300 equities in the same regions with a focus in Japan, and slightly greater exposure to North America (Canada). It is valued at over $31 billion.