The Benefits of International Investing
Much has been written about how international investing enhances portfolios. This is true to some degree, but I think that many people have a misperception about how international investing helps a portfolio. It is certainly true that adding international investments generally lowers the standard deviation or volatility of a portfolio.
International stock prices generally do not move in lock step with US stock prices. There will be times when US stock prices fall while international stock prices rise and other times when US stock prices rise while international prices fall. For example, if on day 1 US stock X falls by 1% while international stock Y rises by 1%, the total price movement of the two stock portfolio would be 0%.
It is important to note that despite statistical evidence that international investing reduces portfolio volatility, the benefits are much better during stable market environments. History shows that the diversification benefits from international investing are significantly reduced during severely negative US markets, just when you need it most. It is also important to point out that different countries correlate differently to the US market. For example, developed countries like the UK have a much higher correlation to the US market than the typical emerging market, which has a much lower correlation. The higher the correlation, the lower the diversification benefits.
Lower portfolio volatility is an attractive characteristic, but many investors do not understand why it is so attractive. If you are a long-term investor that never allows emotion to cloud your investment judgment then the following may not apply to you. With that said, we are all human and it is extraordinarily difficult to completely detach emotions from investment decisions all of the time. Unless you are one of those people that enjoys a roller-coaster ride in the stock market, you will prefer lower volatility. An investment portfolio that returns 10% per year consistently will most likely not have a significant impact on your emotional well being. Accordingly, you may be less likely to make a rash decision and sell the investment.
The misperception about international investing is that investing outside the United States will increase a portfolio’s returns significantly. This is not necessarily true. Of course, if you are fortunate enough to be invested in the right countries, currencies and at the right time, you will most certainly increase returns. The realty is that few investors can consistently get this right. Studies have shown that developed international market performance is very similar to large cap stock performance in the US. According to the Ibbotson SBBI 2006 Yearbook, from 1970 through 2005, the EAFE Index(Europe, Australia and the Far East) returned a geometric average of 11.2% versus the S&P 500 which returned 11.1%.
You have to look at shorter time periods to notice material differences in performance. For example, in the 1980's the EAFE returned 22.8%, while the S&P 500 returned 17.5%. The average investor (and professional), however, will have a difficult time choosing the right markets at the right time. The Editor of the Mutual Fund Investor believes that the average investor should primarily view international investing as a diversifier and secondarily as a return enhancer.