Why diversify outside of the US?
The outperformance of US stocks in recent history has led some investors to question whether they should invest outside the US at all, yet there remains compelling reasons to diversify globally.
US investors often think of the S&P 500 Index (an index of the largest companies in the US by market capitalization) when referring to the performance of the stock market. This is not surprising to hear as most US based investors exhibit a “home bias”, where they focus their investing domestically and less on international. In a Vanguard 2020 study, households they surveyed had 81% of their portfolio allocations invested in the US.
On top of that, US stocks have set a high bar for performance globally, outpacing the gains in stocks across Europe, Japan, and emerging markets over the last decade. It’s become natural to ask, “Can’t I get better returns just sticking with US stocks? Why would my Betterment portfolio have any allocation to companies outside of the US?” Currently, Betterment’s Core portfolio strategy in the 100% stock allocation has a target allocation of more than 40% in international equities.
Below, this piece will cover reasons diversifying internationally makes sense, including:
- The global market portfolio is a starting point for asset allocation
- There’s no guarantee that US stocks will continue to outperfor
- Diversification creates the potential for more consistent returns
Investing in the global market portfolio
The short answer is that Betterment constructs all of our portfolios to be representative of the makeup of global investable assets as a whole, and you’ll find that around 40% of the world’s equity assets are invested outside of the US. International investments play an important role in reducing the risk of concentration in any one particular country within your portfolio.
There’s no guarantee of continued US outperformance
We’ve all heard the phrase “past performance is not indicative of future results.” For instance, stocks of one region can string together multiple years of outperformance relative to others before that trend reverses and it enters a period of underperformance. The chart below illustrates this tug of war between US and international developed stocks. While the outperformance experienced by US stocks over the last decade is striking, international developed stocks dominated in the wake of the dot com bubble in the decade before that.
“International stocks” is represented by the MSCI EAFE Index. “US stocks” is represented by the MSCI US Index. Past performance is not indicative of future results. You cannot invest directly in the index.
Going back further into history, in the ‘80s international developed stocks actually outperformed US stocks to the same extent that US stocks have outperformed since 2009. We believe, and many on Wall Street will admit, that trying to time these cycles can be extremely difficult and a more consistent return may be achieved by holding exposure to each geographical region’s stocks over the long-term.
Before US stocks’ strong run in recent history, investors may have been tempted to allocate more to emerging market stocks based on their momentum during the 2000s. Emerging market stocks had higher returns than US equities in eight of the ten years before 2011. If an investor piled into emerging market stocks in 2011 because of their decade long track record of outperformance, they would have largely missed out on the strong gains in the US over the following 10 years.
There also may be reason to believe that markets outside the US have the potential to post strong gains over the next decade. Based on certain valuation metrics, US stocks appear more expensive than their global peers. For example, companies in places such as emerging markets source much of their revenue from quickly growing economies, which may enhance profitability in the future.
Diversification helps avoid drawdowns and creates the potential for consistent returns
International markets are not perfectly correlated with the US, meaning they do not move in lockstep. Allocating to markets around the world therefore promotes diversification, helping buffer portfolios from the heightened volatility of individual markets.
The chart below ranks the returns of Betterment’s tenured Core portfolio strategy against different regions and asset classes across calendar years, illustrating diversification in action. The Core portfolio, with a 90% allocation to stocks and 10% allocation to bonds, consistently avoided losses compared to the poorest performing assets of recent history. This was also evident in 2020 where diversification provided downside protection as the US fell into a short recession and battled a pandemic.
Investors focused on using the S&P 500 Index to benchmark performance will highlight that the index outperformed our Core portfolio in the time periods displayed. And while the strength of the US market is undeniable, it is important to not overlook the fact that our Core portfolio still has a sizable allocation to the US. Having a strategic, well-diversified portfolio allows investors to obtain exposure to not only markets that outperform like the US, but also to international stock markets and other asset classes that can dampen the downside in years where US stocks underperform.
*See disclosures below
At Betterment, we build portfolios and provide advice on portfolio allocations that should be suitable for each investor’s risk tolerance to help them reach their investment goals. Diversifying across stock markets, whether in the US or elsewhere in the world, helps in that continuous effort. It may be tempting to chase the high returns that US stocks have posted in recent history, anticipating that the US equity market will continue to outperform, but investors should recognize that future outperformance is near impossible to predict and that they should position themselves for a wide range of possible outcomes accordingly. This is why as a foundation of Betterment’s portfolio construction process, we start with a diversified global market portfolio.