How useful is international diversification?

I have a confession to make! In the ERN family portfolio, we have almost no international diversification. We invest the bulk of our financial portfolio in U.S. index funds; FUSVX and FSTVX, which are Fidelity’s (lower-cost) alternatives to the Vanguard Admiral shares VFIAX and VTSAX, respectively. Our international exposure is in the low single-digit percentages. How come, you ask? How useful is international diversification, anyway? Jack Bogle, for example, claims that with a diversified U.S. equity portfolio you will capture pretty much the entire global economy already because U.S. corporations do business all over the world. That argument, of course, is not very convincing. Doing business abroad obviously means that you get some diversification, but it definitely doesn’t imply you get enough diversification from a U.S.-only portfolio. To see how flawed that “revenue from all over the world” logic is, keep in mind that Apple is generating revenue from “all over the United States” but nobody in their right mind would ever call for investing exclusively in Apple stocks as a good proxy for the entire U.S. stock market.

Let’s look at the chart below to see how the U.S. stock market is clearly not a very precise proxy for international stocks. It’s a scatter plot of U.S. monthly equity returns on the x-axis and global returns (both non-U.S. and all global stocks). World ex USA has only a 0.65 correlation with U.S. equities. If for most x-values the blue dots are scattered around the 45-degree line +-/10% or even +/-15% (monthly!!!) then we clearly don’t capture everything going on in the world with a U.S.-only equity fund. (Of course, the overall World index has a much higher correlation; the orange dots are closer to the 45-degree line, but that’s mostly because global stocks already include the U.S. with a weight of about 50%.)

Diversification Chart01
Scatter Plot of U.S. equity returns (x-axis) and global equity returns (y-axis,). The correlation with non-U.S. stocks is only 0.65. All index data from MSCI.

So, diversification could theoretically work! Then why am I not more enthusiastic about international diversification? Very simple:

It’s less about whether diversification works. It’s more about when diversification works and especially when it doesn’t.

Let’s look at the data some more…

To better see when diversification works and when it doesn’t let’s plot year over year returns (though still at a monthly frequency, so each dot corresponds to, say, the May 1999 to May 2000 return, June 1999 to June 2000, etc.:

Diversification Chart02
Scatterplot of YoY returns: U.S. on the x-axis, World ex USA on the y-axis.

When U.S. equities are down significantly year-over-year, say, 20, 30 or even 40% and more then there is relatively little benefit from diversification. As we like to say in the finance industry,

“When the $h!t hits the fan all correlations go to one!”

In other words, if the U.S. goes through a stock market crash then the rest of the world will surely follow. Even worse, when the U.S. suffers a bear market (-20% and worse) or a crash (-30% or worse) the majority of the blue dots are below the 45-degree line, therefore, when the U.S. market went down, global equities tended to drop even more, on average.

That’s the kind of diversification I don’t like! It looks more like diworsefication!

On the other hand, when U.S. returns were between not too awful (>-10%) all the way up to +60%, then we observe significant differences in overseas returns. For example, when the U.S. returned +20%, global return ranged from -10% to +70% on a year-over-year basis.

Summary so far:

International diversification doesn’t work when I need it the most. And it works best when I need it the least.

Thanks for nothing, man!

Two case studies: 2000 to 2007 and 2007 to 2017

Another way to present the data: Let’s look at the cumulative returns of the USA, World ex USA, and World equity indexes, starting at the market peaks in 2001 and 2007.

After the Dot Com Bubble peak in March 2000, all indexes dropped by over 46% through September 2002. The exact figures: USA down 46.15%, World ex USA 46.05%, World 46.31%. So much for diversification in a stock market crash! But it is true that the subsequent recovery was much stronger abroad. After the damage was done if you still had the nerve to hold international equities you would have done extremely well!

Diversification Chart03
A 2000-2007 case study. Global equities exactly mimicked the U.S. Dot Com Bubble crash. Zero diversification! But the recovery was much better abroad!

Now let’s look at the Global Financial Crisis (GFC). The (end-of-month) market peak in all three indexes occurred on 10/31/2007. The USA index dropped by 50.65%, the World ex USA by 56.34% and the Global index by 53.65%. Diversification hurt you during this episode, which is positively amazing considering that the crisis actually originated in the U.S.! If that’s not bad enough, the recovery was much stronger in the U.S. In fact, the non-USA index is still only about 10% above the 2007 peak and that’s before inflation. If you had done what worked best before the GFC you would have been badly disappointed. I’m glad I stuck to my instincts and kept my equity portfolio mostly in U.S. equities!

Diversification Chart04
A 2007-2017 case study. Even though the Global Financial Crisis originated in the U.S., global equities dropped by even more peak to bottom. And the recovery was much worse outside the U.S.! Dot Com Bubble crash. Zero diversification!

Update: More historical data

As requested by folks in the comments section, here are more observations, including other drawdown periods and also the S&P500 (very closely correlated to the MSCI USA) and Emerging Markets (the non-US index used above was only developed markets). Notice that the EM index became available only in December 1987.

The same pattern emerges. In a U.S. market drawdown, everybody suffers. Worldwide. During recovery periods, we see a lot of variation in returns. For example, very strong returns in the U.S. during the 1990s, lackluster returns abroad. But in 1982-1987 that was exactly reversed.

Diversification Table01
Real (U.S.-CPI-adjusted) total returns of various indexes during drawdown and recovery periods: 12/1969-5/2017. Notice, EM is available only after 12/1987.

What I’m not saying about diversification

Just to be sure I want to make these two points really clear:

  • I very much prefer indexing over investing in individual equities. Diversification is essential to alleviate single-name equity risk (think Enron, Lehman Brothers, Bear Sterns, various airlines, etc.). Someone could incorrectly deduce from my post that I also propose holding only a handful of nationwide operating U.S. equities (e.g., Apple, Google, McDonald’s, ExxonMobil, etc.) and we got the whole U.S. stock market covered, right? Wrong! You’d have a vastly higher portfolio risk. Indexing is the way to go, folks!
  • This post is written from the perspective of a U.S.-based investor. When the U.S. economy struggles the whole world will feel the effects. In contrast, smaller countries can have recessions and market crashes without much of an impact on the rest of the world. So if you live outside the U.S., you’d greatly benefit from investing outside your own country!


If you want to use international diversification to hedge against big losses in your U.S. equity portfolio then think again. The two most recent market crashes in 2001 and 2008/9 were just about as severe or even worse abroad and the reason is obvious; the U.S. economy is too large and too influential for the rest of the world to escape the mess. Remember, here in the U.S. we are the “consumer of last resort” thanks to persistent trade deficits, and when we have a slowdown the whole world will notice.

That’s not to say that diversification doesn’t work. International stocks would have worked great coming out of the 2001 crash. But they would have also severely lagged behind the U.S. market coming out of the global financial crisis, compliments of the Euro crisis and other issues abroad. In other words, apart from being non-existent during market crashes, the benefit of international investing has been very episodic outside of the big recessions. But I have to concede that international stocks look very inexpensive today, measured by their CAPE ratio, so I might move more into international equities. But I have the feeling it’s more market timing than diversification!

What’s your view on diversification? Please share your thoughts below!

107 thoughts on “How useful is international diversification?

  1. Perhaps it is useful to think of there being different correlation levels or diversification benefits depending on time frame. US and non-US seem to be much more correlated in the short term than the long term. Yes, annual returns are highly correlated, but US can handily beat non-US one decade, then the opposite happens the next decade, leading to much lower correlations on multi-year returns.

    So, yes, within 2000-2007 and within 2007-2017, international diversification didn’t buy you much either time, but it did buy you something over the longer span of 2000-2017. As a long term investor, I care about long term implications more than short term behavior. Over *my* long investing time horizon, which is the time horizon that matters most for me, international diversification should smooth out the ride. My worst years will be as bad as US-only worst years, but my worst decades should be better than US-only worst decades.

    1. I agree with this, the example shown in how World ex-US beat the US index in 2000-2007 basically shows that the diversification is a good thing. I disagree that this in any way proves that you don’t want diversification. You may or may not be better off without it, but those charts alone show that it does have some benefit in some scenarios. You also do not know what is coming in the future so it would probably be foolish to assume that correlation will increase or decrease going forward, it could be either one or it could be dependent upon a variety of factors. Personally in my equities portion of my portfolio I hold 75-25 US-INT, which still overweights US, but I think some diversification is a good thing.

      1. Thanks for sharing! If world-ex-US beats US during 2002-2007, then this shows that “diversification” was a good thing in 2002-2007. Not overall. Otherwise, you’d have a pretty low bar for calling something “a good thing” – basically, any asset doesn’t suck all the time would then be a good thing?

    2. Thanks for the comment! Yes, that’s a good point. Over longer windows, like 10 years, international diversification helps soften the worst observations.
      Personally, I find 10 years a bit too long. For sequence of return risk considerations I look at 3-5 year windows. And over that horizon the global drawdowns are just as nasty as he domestic ones.

      1. I think you are right that diversification would be most helpful for getting rid of sequence of return risk. As that risk is the biggest one when FIREing. And you proved that for this particular risk international diversification does not matter much.

        However “10 years a bit too long” – why does that not matter? Reducing risk in the long term (10, 20, 30 years) is also very important?! History shows that countries can have a bad few decades. So focusing only on the US seems like “betting” on one country, similar to choosing only one stock and not an index.

        1. And that’s exactly why investors from other countries should diversify. Japan had a horrible performance since the late 1980s. If the U.S. economy were to implode like the Japanese then the effect will be felt everywhere. There will be no place to hide from that.

          1. “There will be no place to hide from that” That seems a weak conclusion, unprovable and overly optimistic of US as special place of the future – in regards of returns. Valuations affect future returns (over decades) probably more than any other considerations.

            1. Agree. It’s unprovable. Just like scientific claims, this is something that we can only disprove. To disprove my theory, I’d need to see a 10+% drop in the S&P500, while the rest of the world stocks go up. Never happapend in history.
              Didn’t happen after I wrote this post: Didn’t happen in Q4-2018, didn’t happen in Q1-2020. So, after writing my post, I’m already 2/2 “supporting” (not proving!) my theory that “there is no place to hide from a US stock market correction”. But again, we can never prove it positively, we can merely gain confidence when we don’t observe what would disprove my theory.

              We will see how the next correction plays out. If you want to wager a bet for $1,000 and you believe that non-US stocks will be up during the next 10% S&P 500 correction, please contact me.

              1. I would mainly call it data mining 🙂. That is not physics as you already know. But hey, I dont count on “best returns” for my retirenment, don’t even need to bet on anything to reach my objectives – being as broadly diversified as possible.

                1. Well, physics tends to be much simpler, I know. It’s replicable, it often boils down to some simple differential equation. Economics and finance on the other hand are more chaotic and complicated, and we have to work with what we have here.

                  Also, it’s not data mining. There are tangible theoretical economic reasons for the connection between US economic cycles and cycles in other countries.

  2. I think nowadays European and US stock markets are highly correlated and agree that diversification is not very meaningful here.

    It would be interesting to explicitly look at the effect of diversification into emerging markets. I would expect that there is significantly less correlation with Europe/US, and thus adding an emerging market allocation to your portfolio can be beneficial.

    Apart from this I do believe that the market is pricing in an excessive risk premium for emerging markets. Comparing current valuations vs long term economic and population growth prospects, and considering investor bias for their home markets. But that’s for another discussion on market efficiency.

    1. Great point. I added a table that also looks at the drawdown and recovery experience of EM. The same pattern emerges: EM was hammered during the GFC. And has recovered less than the US since. But I agree: now EM is so inexpensive that it looks like an attractive asset!

  3. Interesting conclusion ERN.

    You’ve picked two case studies, with opposing outcomes, and reached a conclusion. Readers may conclude you picked the one you liked the best, or supported your pre-existing assumptions.

    What would be very interesting is to run the same kind of longer time series you have previously done for some of your S&P500 analysis, which gives you a few more significant downturns upon which you may draw a more evidence based conclusion.

    I’m not saying you’re wrong (personally I suspect you are probably right about non-US markets generally underperforming in comparison), but a few more data points would strengthen your argument.

    Keep up the good work!

  4. In my mind the biggest reason for country diversification is a large-scale disaster that could permanently impact the economy. Think Fukushima in Japan as an example. While it was contained (more or less), at a different time and on different circumstances it could have caused much greater havoc.

    Something like this cannot be measured by historic data because there is no historic precedent.

    1. I disagree that there are no historic precedents.
      Japan in March 2011 is exactly what I was referring to: “So if you live outside the U.S., you’d greatly benefit from investing outside your own country!”
      That earthquake was a disaster in Japan and non-event everywhere else.
      9/11 was bad for the US stock market and for all global markets. So was October 1987.

      1. Big ERN you are American, I take it. But when it comes to unpredictability USA is no special. Also considering the last 4 political years under T* as an international investor I won’t bet majority of my money in USA.

        1. ” when it comes to unpredictability USA is no special”

          I never claimed that. The entire point of the article is that the unpredictability of the US stock market coupled with the lack of diversification from non-US stocks during the major bear markets makes it less attractive to diversify.

  5. Ha! If FL was still bloggin, he would be over here with a large (European made) stick to whack you round the head! He was a big fan of a global equity portfolio….

    I must admit, we have huge faith in the US economy and with some help from the administration, (ahem….still waiting), it will get better.

    We did exactly what you hinted at at the end of the article- we made a move back end of last year into a bit more more International – emerging, developed, total. We are at ~3:1 right now in terms of US: ex US. Meb Faber would still scold me for not doing more!!

    It has paid off handsomely this year and we need to see it run a few years before trying any more market timing shenanigans. We got lucky with our timing. We are not playing that game again as it was counter to our normal habits.

    I just did a quick Portfolio Visualizer plot of VTSAX vs VGTSX from Dec 2000 to now. I see your point on diversification with this quick & dirty back-test. Especially like your dot plot which says it all.

    If you were going to pull the trigger on increased ex-US equities, what would seal the deal for you to make it happen??

    1. Yeah, maybe FL will come out of hiding because of this one. I remember he had a good post on diversification in January.

      For the last year, I have added new investments to an ACWI-ex-US (all country world ex US, which is DM and EM). I’m still unsure about outright selling US and buying non-US, though.

  6. What about over longer term periods? Like you said, the US has significantly outperformed international over the past 10 years, despite their high correlation. Doesn’t that imply that it could go the other way for the next 10 years? How did things look in, say, the 70s, when US stocks did poorly and some other countries (especially Japan) did great?

    1. Ha, good point. I think there could be something of a reversal again going forward. After the next bear market when all indexes go down in-sync, maybe then it’s time to bet on non-US stocks during the subsequent recovery. THat’s definitely something I consider!

  7. You clearly know vastly more than I, but this still has to me a whiff of recency bias. In 1969, the year your earlier data set starts, the US GDP was 38% of global GDP. It is currently 22%. US was over 60% of global market cap in 1969, it is now less than 50%. Yes the US is obviously very important in the international economy, but ???

    Even if there is no longer any diversification benefit, why needlessly make the bet that US will outperform international? You mention at the end considering International on valuation based arguments, but is there any history of prospectively being able to predict the relative returns of US vs Int’l based on those valuations?

    Guess I was sold by Vanguard’s white paper. I’ll just keep my Int’l stocks at 1/3 of total equity.

    1. Yeah, isn’t it amazing that despite the lower share in world GDP, the U.S. is still the growth engine?
      Also, I’m not the one claiming the U.S. will outperform non-U.S. In fact, I’m the one pointing out that during the next U.S. bear market, my non-U.S. portion will likely fall by roughly the same percentage.
      Also: valuation can work when timing the allocation across countries. But it’s not an exact science because one has to have a sense of what’s each country’s “normal” valuation. The U.S. with high trend growth would have a very different neutral CAPE from Japan.

      1. With different segments of the markets (small cap, value, large cap, EM, Int’l, etc) having different historical valuations (CAPE), I think a study into portfolio allocation based on current CAPE of the market segments with guard rails on percentage of allocation would be interesting. Then again this would be market timing.

        1. Yup, I’d try to stay away from timing. If you already hold an all-US fund, there is no need to hold additional small caps.
          Though, I was thinking about doing an efficient frontier analysis with a bunch of different assets, including small/large, international (DM and EM), bonds, commodities, etc.
          It’s on my to-do list. 🙂

          1. Ahh… the efficient frontier analysis. This was exactly what was on my mind. Because if I run one of those, isn’t there a slight hedging effect with the international equities?

            1. Thanks for stopping by! The efficient frontier analysts is useful and useless at the same time. It all depends on what you assume for expected returns and the variance-covariance matrix. If you trust your estimates then it’s useful, but with even a bit of uncertainty especially about the expected returns you can get any result you want.

  8. I think the diversification argument is missing the point. Maybe it helps, maybe it doesn’t but I don’t believe that’s the key point.

    If your main return driver is nominal GDP growth, and for almost all FIRE followers investing in VTSAX it’s just that, then having a huge home country bias is missing 50% of the opportunity set. As you point out US cap is about 50% of global cap and even with the erroneous argument that Coke and Apple give you overseas exposure you are missing a lot of global growth opportunities. If you believe that there are serious demographic issues and structural changes to the US workforce that will restrict future US GDP growth, and there are better opportunities for GDP growth in other countries then international equity exposure is rational.

    Of course you need to take some kind of tactical view on entry point around valuation. If the market thinks the same as me then any future growth will be priced in, but valuations for non-US are pretty good at the moment. So I’m advocating a more global view but am also happy with some home country bias. My EM fund has out-performed the S&P500 by 17% this year – Yowzer!

    1. I’m glad you mention GDP growth! As I pointed out a while ago, the stock market follows fundamentals and you can’t get much more fundamental than GDP and GDP growth:

      But you’ll be shocked to see that the exact same argument I made about stock returns also applies to GDP growth. When the U.S. goes into a recession then everybody else will suffer too. When Switzerland has a recession it has no bearing on U.S. growth. Heck, even a country as big as Japan suffering its third “Lost Decade” in a row didn’t derail U.S. growth.

  9. I think that’s the same correlation argument again in a different guise. Yes I agree, if there is some short term shock to the US that impacts on Switzerland and Japan. But I’m playing the long game – I’m talking about the long term systemic decline in GDP growth from rising dependency rates and a declining productive younger workforce propping up an aging population that can’t afford healthcare and their pension promises.

    Illinois public pensions are a case in point – 30% funded on an 8% discount rate! That will blow up with a declining worforce paying fewer taxes.

    1. I don’t want to be in the business of predicting what causes the next crash. The demographic transition is a train wreck, I agree, but it’s an extremely slow-moving train wreck and everybody is aware of it. I would be surprised if it causes a sudden market move. But even if it did, it’s the one reason to again avoid non-U.S. stocks. The demographic imbalances are worse in Europe, even worse in Japan, South Korea and China.

  10. When America sneezes the rest of the world catches a cold.

    As you mention at the end of this post, you might gain a slight edge from market timing (due to lower ex-USA valuations) or factor investing (like emerging markets)…but that is a very specific gamble and hardly meets the criteria of a passive strategy.

    I don’t think “diversifying” into a bunch of other advanced economies that face the same demographic issues we do gets you much of anything. Especially considering their demographic situation is actually worse, their economies are completely entwined in ours thanks to globalization AND they have much more restrictive capital and labor markets (arguably the reason the global recovery was so much more sluggish than ours after the financial crisis.)

  11. I think one of the best things about you ERN is that you take the time to make the exact same graphs and research that I’d make to figure out a situation (although our conclusions sometimes differ, which is healthy). Some of them I’ve already “figured out” , some not yet. It always helps to listen to a well thought out (and differing) viewpoint. While I’m a big fan of 10-30% international lately I’ve been questioning that logic myself. Now if you’ll excuse me I have some numbers to crunch for the millionth time!

    1. Oh, wow, thanks for that compliment.
      I can’t argue with 10-30% international. It won’t hurt you. But I have the feeling that it won’t help much in the next bear market either. We shall see! 🙂

  12. Great analysis.

    I decided 2 years ago to add to my IWDA (wolrd developped countries) tracker some EU smallcaps and Emerging, so that I only have 40-50pct US exposure Looks like that is not so needed. Maybe my homebias is hurting me.
    That being said, I have the exchange rate that impacts and changes the outcomes a lot. Yes, global countries operate worldwide, so we all have exchange rate impact. I can only hope that global firms can balance a little their CCY exposuer by matching income and expenses.

    1. Well, you seem to be very appropriately diversified then. I’m not arguing that non-US investors should hold 100% US equities. That’s problematic due to exchange rate risk. So, for non-US investors, the world index should work great!
      Thanks for sharing and good luck!

  13. Very original and thought-provoking, like always!

    A few caveats, though:

    1. US-only is an active trade. You might be in it passively, but you are still picking a country. Admittedly, it’s a trade that has worked great over the last century plus, and odds are high that it will continue to work in the coming nearby decades. However, for those with perhaps 60-year investment horizons, I’m not sure that it’s wise excluding almost 50% of the opportunity set. It is quite likely than in a few decades time, the US’ share of the world economy will be less. In part, great US investors (Jack Bogle, Warren Buffet, etc.) have been very successful thanks to their skills (coming up with the idea of a passive fund also takes great skill!), but also thanks to being born in the right country at the right time (Warren Buffet’s “ovarian lottery”). I very much doubt that they would have produced the same results outside the US. Believe it or not, there are also highly-skilled fund managers outside the US.

    2. Limitations of length of data set. I am aware it isn’t your fault that e.g the Emerging Markets indices only go back to 1969, but it’s quite a limited data set, and, even if you had the past 100 years “a la” Jeremy Siegel, again, we’re talking a century where the US has vastly outperformed.

    3. Limitations of using historical data. As you very well know, the usefulness of using historical data to forecast future returns (and anything) is quite limited. For example, a lot of Europe has indeed suffered a “lost decade” during 2007-2017, but as you rightly mention, the CAPEs right now are at more attractive levels and growth is slowly trying to pick up, while the US’ CAPE is gradually lurking towards bubble territory, albeit far from it still, in my personal opinion, so the “game” isn’t over. Plus, again, the last 100+ years of the dataset have a massive structural bias of US outperformance, which may not be so over the next century.

    1. Thanks for your thoughts. I’m not trying to talk anyone out of international investments. I mostly rationalize what I’m doing. I am aware of the data limitations and how past results are no guarantee of future outcomes. But remember: I’m not the only one making predictions. In 2004/5 I remember hearing people talking about decoupling of economies. Only to experience 2008/9 and seeing that decoupling was bogus. I wouldn’t want to bet on decoupling next time around.
      Also, recall that ex U.S. has outperformed the U.S. since 1969 (see table with mean returns). The results presented here are true despite the U.S. average underperformance. If the U.S. goes into a bear market everyone else does, too.

  14. (I forgot one additional point and cannot edit comment)

    4. You cannot pick bottoms. You can see them in hindsight, but it’s almost impossible to know beforehand. In most cases of the data analysed, Global outperforms in the recovery, but you can’t just go US-only while the drawdown is happening and then time the market perfectly, buying into international to pick up the outperformance on the way up.

  15. I’m not saying you claimed a need for perfect foresight.

    What I’m trying to say is that in most cases from your sample the global recovery outstripped the US one, so, although indeed there does not seem to be much downside protection benefit, there seems to be benefit on the upside.

    With perfect foresight, assuming one wants to maximise returns, the rational thing would be to run US-only during the bull run and eventual drawdown (as it’s slightly lower than the global one), and then at the bottom add international to reap the potential recovery benefits.

    However, as there is no perfect foresight, the best thing one can do is simply go global.

    1. I never claimed that we should time the US vs ex-US allocation and allocate to ex-US during bull markets. It wouldn’t have worked during the 1990s and it wouldn’t have worked during the 2009-2017 bull market either.
      All I’m saying is that we’re 8+ years into a bull market. The next bear market might happen this year or next year or in 10 years. When it does happen I expect no diversification benefit from ex-US. That’s all. I might surmise (not forecast, just surmise) that after that next bear market, maybe, maybe, ex-US might again outperform the US during the next bull market, considering how pathetic the ex-US performance has been since 2009. But even if that is my forecast, I can sit back and wait for the market to drop by 20-30%. Remember, I don’t have to time the bottom. On the way down US and ex-US will likely go in sync. All I need is to shift into ex-US around the bottom not at the bottom.

  16. Nice article. I heartily agree with the point that during panics, the correlations to the downside will likely increase. I always laugh when I see people doing back testing and saying, “My diversified portfolio only collapsed by -39% instead of the index’s -45%.” Really? Is anyone going to be dancing in the streets (or sleeping better at night) with a slightly less terrible outcome?

    For me, diversification is just about spreading the risks and dealing with uncertainty. I have no idea what will happen tomorrow. It may look totally different than yesterday. So, I diversify to a moderate degree. Do I expect that my portfolio will substantially outperform in the next down turn? No. Do I expect that my portfolio will substantially outperform the S&P 500 in the next global bull market? No. I just don’t want to be stuck in one just one type of investment at exactly the wrong time, in exactly a disastrous time. (Think of Bernstein’s deep risk.) Some might say that’s an irrational, fear-driven decision. But I think if you take the perspective that we know less than we think we know (ala Charlie Munger), then a moderate amount of diversification seems rational to me regardless of how many back tests you do.

    1. I see where you’re coming from. International diversification is a hedge against some unknown unknown (as opposed to a known unknown).
      I might slowly shift some more money into international stocks because of that. But I have no illusions about diversification benefits when the next bear market hits.

  17. I’m not sure of the statistical significance of the second scatterplot. The ellipse contains quite a few points, but they are month-on-month, and I’m guessing those points only represent one bear market event (2008) or two. If that’s the case, I don’t think you have enough historical data to conclude that US will out-perform non-US during drawdown extremes. Remove the lowest 13 or 14 points (just over a year), and you likely have no difference between the two.

    1. Look, nothing is significant. We are talking about a handful of drawdown episodes. But I found it striking that the ex-USA drawdown is roughly the same as the US drawdown. We can wait for another 200 years to gather enough data to draw a statistically significant conclusion. But I want to know what happens in the next U.S. bear market. My philosophy is to not expect too much diversification from international stocks. I find that more prudent than the “next time will be different” view.

      1. Thanks. Your analysis is still interesting, of course, since I figure the biggest justification for my international diversification (currently at 36% of total stock) is for those events that disproportionately affect the US. And yet the 2008 bear market wasn’t such an event, I’m guessing because the initial impacts in the US exposed structural weaknesses in the Eurozone.

        1. Yes, that’s exactly what happened. And of course, some of the the crummy securities from the U.S. mortgage industry were marketed to international investors. Thanks to Lehman Brothers and gang, a lot of the bad stuff was “diversified” to buyers from other countries which then contributed to the lack of equity diversification when the crap hit the fan. Such irony! 🙂

  18. Analysis proved my hunch that globalization has pretty much eliminated the ideal benefit from international diversification. At the beginning of the year I moved back into a 75/25 allocation US/ExUS not for diversification but because of the value I was seeing in international equities when looking at their respective CAPE ratios.

    I think at the end of the day we should all just trust our instincts and look for value no matter what the asset class.

    Great analysis as always ERN

    1. Thanks, Matt! 75/25 sounds like a great compromise! Kind of a hedge against a U.S. market fizzle while the rest of the world catches up. But if there’s a another real bear market, there’s no place to hide.
      Thanks for sharing!

  19. This is off topic from diversification during a bear market, but ultimately I suppose the main goal should be something approximating highest long term returns (given desired risk).

    You show that the relative performance of U.S. vs. international is very “lumpy.” One outperforms the other for many years at a time, until a change happens. If this pattern continues in the future, it could be very profitable to watch for it! Do the changes necessarily line up at U.S. bull/bear transitions, though? Maybe you’re shoehorning that conclusion in.

    Gary Antonocci at shows strong long-term portfolio outperformance in simply switching between the U.S. market and ex-U.S. market based on 12-month relative momentum (evaluated monthly). It’s timing, but if it’s wrong, then the momentum anomaly doesn’t exist possibly in one of its simplest forms (asset class level). That strategy indicates to switch to ex-U.S. now regardless of where we are in a market cycle. The beauty of the strategy is you don’t have to know or care about market tops or bottoms.

    Also, this graph seems to show the lumpiness of U.S./ex-U.S. has potentially reached a bottom and passed its inflection point (rising line means foreign developed markets are outperforming):

    and same for U.S./emerging markets (rising line means emerging markets are outperforming):

    I’ve increased my international allocation to 37% in my long-term savings (tax-deferred portfolio).

    A lot of financial advisors seem to be in agreement to increase ex-U.S. allocation. The contrarian in me worries about that. But Gary’s (backtested) data is solid in its simplicity, and it agrees with most of what you’ve shown above (though it will trade more often). On top of this, I think it’s very difficult to dismiss fundamentals like a hefty valuation difference (U.S. richly valued), which must eventually resolve itself by the U.S. underperforming.

    1. Scott,
      Thanks for this very insightful comment. Momentum strategies are quite intriguing. Especially when outperformance is episodic (Stocks vs. Cash or US vs non-US stocks) a simple 12-month momentum signal seems to work pretty well. Definitely, this is something to consider now because non-US Developed markets (e.g. EFA ETF) and Emerging Markets (EEM ETF) have outperformed the U.S. over the last year. But again, this only works if we have faith that this outperformance will last for at least another few years.

      1. Just getting around to reading this excellent article in August 2020. Is it now reasonable to conclude that increasing one’s ex-U.S. portfolio allocation back in 2017 based on a 12-month momentum strategy at that time would have been a bad move, in retrospect?

        I’m also curious to know what percentage of your current index portfolio is invested in US versus non-US funds.
        Do you plan to modify those percentages in any direction going forward? Thank you!

  20. Great post and case studies. I’m curious as to whether you’ve looked into trend-following or using momentum type filter for your portfolio that may result in switch from US to ex-US equities but may not lead to diworsefication.

    1. Yes! I like the idea of trend-following for these large macro trends that can last for almost a decade. Probably look at the price momentum over the last 9-12 months and use that as a signal to time U.S. vs. non-U.S.

  21. A lot of the points people are making about international CAPE ratios being low, lumpy performance, etc., are I think things you don’t necessarily disagree with/think merit research, Big ERN, just not the point you’re making.

    Specifically to the point your making, I will be interested to see how our trade deficit evolves under Trump. If we do see significant changes, seems like that may lead to more uncoupling of our downturns effecting other countries.

    1. Yup, we’re the consumer of last resort. If that ever changes we may no longer export our recessions to abroad.
      But I still think with or without Trump, we’ll have a trade deficit. He’s more talk, less action on trade wars. 🙂

  22. your argument is historically accurate but may not be accurate in the future. America may not represent as large a portion of the global equity market in 2030, given the growth of china and india, and the significant debt in the US. WeChat could singlehandedly knock the Nasdaq into a drawdown if they expand worldwide.

    1. Good point! Time will tell. But again, I remember the chatter about decoupling in the mid-2000s for this exact reason you mentioned. But then everybody was surprised again how tied everybody is to the Good Old U.S.A.!

  23. I just came across your blog and I really like it a lot!
    Great analysis and looking at the relevant data here! I read Jeremy Siegel’s book and thought I needed more foreign stocks in my portfolio. Your first data plot is very relevant. I don’t think I will invest significantly in foreign ETFs until the rest of the world becomes a bigger portion of the overall market. As you mentioned, the US economy is too large and has a large impact on other countries.

    Looking forward to more great articles!

    1. Thanks for the feedback! Glad you found this helpful! For full disclosure, I have been adding slightly to my international equity funds. But I have no illusion that this will help me much in the next crash! 🙂

  24. Hi Karsten,

    From your February 2018, Millionaires Unveiled podcast: “It’s on my mind every day. Why am I not more in international stocks?”

    Is that still on your mind every day?

    All of the Vanguard target date funds have 40% of the equity allocation invested in the international fund since 2015. In one of their webcasts, a Vanguard employee indicated their expected outcome of international diversification is to reduce volatility, not increase returns.


    1. Great point! We’re still vastly under 40% international stocks. I added all new investments in 401k (when I was still working) to the international fund. But the bulk of investments is still in the U.S. only.
      And again: I also like diversification, but as I showed with that chart: correlations go to 1.0 when I really need it, i.e., when we have the next crash!

  25. Fantastic posts, I am binge reading your blog as I came here through the SWRs serie. Maybe the analysis to a question that sits in my heart and mind is already there and I haven’t found it yet, although I tried!

    You are looking at diversification (or home bias) from the perspective of a US FIREd, I am a European, living abroad but looking to move back to my home-country (a EURO one) when/if I go into ER after FI.
    All my investments are in the home-country out of necessity (expat, salary still gets paid there, as it was all along the past 10 years as expat in various locations).

    So, what is the right amount of home-bias, international asset allocation I should be looking at.

    Not to say that in general there is very little analysis and research on SWRs, asset allocation tailored to European FIRE community. Any chance you’ll be interested in filling it the gap and target that niche?

    1. Nice! Thanks for sharing! The reason US investors can be “lazy” with diversification is that ~50% of the market cap is in the U.S., so you’re not too far away from market cap weights when you go (almost) all in U.S. stocks. Also, the remaining 50% of world market cap is highly correlated with the U.S. market because a U.S. recession will spill over pretty much everywhere else.
      Not so for the investor of a small EU country. I’d at least diversify over the entire EU area and probably hold some additional share in non-EU stocks.
      I don’t have a long enough history of stock/bond returns for non-US so, unfortunately, I’m not going to tackle the non-US perspective of SWRs anytime soon.

        1. As a general disclaimer, I can’t vouch for other people’s numerical results since I don’t know how those numbers were created. “I never trust any statistics that I haven’t falsified myself” 🙂
          There are no details on what numbers exactly are displayed there, so I would use caution. A few observations:
          1: if they use a 40 year horizon and start in 1970 they are working with only a very few true 40-year windows. They would have missed the real disaster windows starting in 1929 and 1964-66.
          2: The U.S. number seems incorrect. I found a fail-safe SWR of 4.01% for 1973, which is quite a bit lower than their ~4.35%. This is for an 80/20 portfolio.
          3: caution with the number for Germany. Nobody in their right mind would argue that a 10% stock, 90% intermediate bond portfolio would support a 4.6% SWR today. German bonds yield essentially zero!

  26. Hi ERN. I just read this excellent article in August 2020. Is it now reasonable to conclude that increasing one’s ex-U.S. portfolio allocation back in 2017 based on a 12-month momentum strategy at that time would have been a bad move, in retrospect?

    I’m also curious to know what percentage of your current equity index portfolio is invested in US versus non-US funds.
    Do you plan to modify those percentages in any direction going forward? Thank you!

    1. My personal portfolio? it’s in the single digit %. Way less than the non-US market cap.
      Now could be a good time to shift, considering the big runup in the US Market. But then again, I’m afraid that Europe will have trouble picking up the pieces post-COVID and start growing again. I think the economic recovery might be faster in the US. Maybe I’m just procratinating, but I’m still not 100% OK with non-US stocks.

      1. I guess I’m also a procrastinator haha. Over the years I’ve been hesitant to buy any non-US stocks (currently 0% of my portfolio), but this recent article by the analysts at Vanguard was an interesting read:

        “Returns for non-U.S. equities over the next ten years are likely to be higher, too, around 8.5% to 10.5%, a differential versus U.S. stocks that underscores the benefit of international diversification.”

        One of the Fidelity “Zero” fee funds is an international index (FZILX). I’m wondering if after a decade of under-performance, perhaps now is a good time for a long-term buy and hold investor like myself to add some international diversification to the portfolio.

        1. Yeah, nice link! The most recent market moves have created even more disparity in global valuation measures. And makes non-US stocks even more undervalued. I’m thinking about moving some of my money. Sounds tempting, especially with the zero% Fidelity fund…

          1. Looks like the disparity has continued since Aug…. Have you tilted your Ex USA to a higher percentage yet? Definately tempting. Would be interesting to update the charts to 2020 numbers to see how big the disparity has become. Also looks like small cap and value are starting to outperform in the very short term…..

  27. Given US has continued to outperform most of 2021, is now a good time to tilt towards international like VXUS?

    1. US has outperformed for the past decade, this trend might continue it might not. I’d just stay the course and not try to speculate based on 1 year fluctuations. In the 2000’s international generally outperformed the U.S.

      Pick whatever makes sense to you, either US only or total world (~60% US/40% international) or somewhere in between.
      FWIW, vanguard’s 2022 outlook expects international to outperform (mostly due to lower PE ratios) but they’ve been saying that for the past few years and have been wrong.

    2. The shift into more international stocks has been on my to-do list for a long time. Never pulled the trigger, though. I’m afraid that non-US stocks are cheap for a reason due to anemic growth. Recurring pandemic shutdowns in Europe don’t help either.

      1. Perhaps I am being a bit stupid (I did run 20 miles today which always dulls my mind for the rest of the day) but I am wondering to what extent currency influences the diversification benefit especially in time of crisis. I am also wondering how this plays out in the US versus say the UK, i.e. reserve currency versus non-reserve DM currency. The Euro probably has some reserve characteristics but the GBP is looking a bit neglected these days.

        Perhaps given the timeframes it all levels out as FX is fairly stable in the medium to long term however given the rush to dollars that has happened in modern crises then I think there is a currency effect.

        I chose global equities as a UK investor some time ago (even though about 75% of FTSE100 income is from overseas I wouldn’t fall for the FTSE100 is Global investing) largely based on Meb Fabers thinking in Global Asset Management (now free but it was worth every pound at the time of release).

        See the Nominal versus Real Returns and volatility for 1973-2013 on page 29. I enjoyed this book and frequently return to it for little nuggets that interest me.

        Recently I have been wondering if I would be better off investing in S&P500 (given recent returns history) or sticking with MSCI World given that it shields me from political risk. However being British gives a sense that being top dog doesn’t last forever (I guess Italians/Romans have the same feeling and the Greeks too).

        One thing that I think is less important with equities but is important with bonds is that investing in the USA means that during a crisis gives an additional hedge in that the dollar strengthens.

        So to tinker and go S&P500 or to stick with MSCI World… at the moment the elevated CAPE of the S&P500 and the desire not to trade without very strong reasons for doing so means that like a mirror Big ERN I am sticking where I am (MSCI World) but continuing to mull it over.

        My only recent trade was to move some of my wife’s cash into TIPS! I am overly cautious with her money.

        1. FX movements are a big concern. As you stated, in a large enough crisis one would expect for the dollar to strengthen.
          And also the subsequent recovery depends on the FX movements, which explains some of the divergence in the non-crisis periods.

          One viable option would be to use FX-hedged equity funds. They come with higher fees, though.

  28. I just noticed that Vanguard’s Total International fund should close around $15 after today’s bloodbath which almost all the way back at its Mar 2000 peak of 14.32.
    Talk about a lost 2+ decades! (excluding dividends)

      1. Yeah it has.

        It seems like their aging population combined with their shift to less pro-business policies have hurt them financially. Of course, some of their policies do have non-financial social benefits though.

        1. I know that recency bias makes this hard to imagine but valuation matters in the long term and I would expect mean reversion for both European markets and currencies. That’s why I retain my international diversification. However I don’t expect it to happen before we hit bottom as the USD and US market are the reserve sanctuaries of choice in bear markets.

          1. Yeah, I have a few % in non-US stocks too. Thought I would shift more out of the US after the 2020 bear market. But I never pulled the trigger. Glad I missed the boat! Europe in particular has some real growth challenges. It’s cheap for a reason. And the US will likely maintain its sanctuary status, as you put it.

          1. Do you expect you’ll make a blog post when you think nominal bonds and duration are starting to look attractive? I am not sure I will time the move very well but you are much smarter than me 🙂

              1. Thank you. I hesitated last time. I had forgotten how difficult timing the bottom is. I don’t remember living through a situation where there were so many different risks at play at once. It may be a failure of memory but previous downturns have seemed more focussed. There are signs of strain in so many areas but so far nothing has broken. The good news is that a correction derisks the market and economy.

  29. Hello Big ERN, thanks for the very insightful post. As a non-USA person I tend to invest in the total world market like VT to reduce the risk of currency exchange but I am still not sure about that.

    My question to you is: Are you able to make a study with the correlation of the DXY with the past recoveries of the markets?
    I am wondering if deciding to have a portfolio majorly formed by USA etfs, like your portfolio, on the good past recoveries of USA markets I am still liable to loose money because dolar weakened during the period.

    I know that dollar works as a “safe haven” during crashes which already serves as a protection for a foreigner with living cost in another currency but in the case of the opposite happens and the dollar weakens with the S&P going well I will be losing money for a while and during retirement period it can be very dangerous.

    1. Good question. Haven’t done that yet. But you certainly deduce from the table I posted here that during the recoveries, everything is possible. For example, the great recovery in non-US stocks post-2003 is mainly due to FX movements. So, a good bit of the differential movement outside recessions is due FX movements and they can go either direction. There is no fixed pattern.

      1. Thanks for the answer =)! So another point for a foreigner keep a global diversified portfolio and reduce risk as there is no fixed pattern.

  30. Hi Karsten,
    Have you considered how much of the US market performance relative to Rest of World the last 10 years has been due to the combination of cheap money and growth stocks?

    1. >Rest of World the last 10 years has been due to the combination of cheap money
      If you thought the U.S. had cheap money, the rest of the world had $18 Trillion in negative yielding debt at one point and NEGATIVE 0.5% mortgages in Denmark and other countries

    2. Everybody else did the same thing or worse. In fact, the US started raising rates before the ECB.

      But you’re right, growth stocks certainly contributed to the outperformance earlier. And also the underperformance now.

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