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%.)
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.:
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!
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!
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.
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!