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Growing up in a small Pennsylvania town, I had a limited world view, and even though my first trip overseas was many years ago, the details of where I went, what I ate, and who I talked to are unforgettable.
Why was it so thrilling to be so far from home? Because it was different—vastly different from what I’d grown accustomed to. Just as we should travel overseas when we can, so should we invest internationally.
Plan a smoother trip
Diversification. We get it. But in my conversations with institutions, financial advisors, and individual investors, I sense a growing reluctance to continue to allocate assets to international investments.
While multiple factors may be behind this, a desire for higher returns is a common motivator. For instance, when U.S. stocks outperformed international equities by 102 percentage points over the three years ended December 31, 1997,¹ the investment rationale around the concept of maintaining diversification was readily overlooked. Then, following the “tech bubble” sell-off, international stocks proceeded to outperform the U.S market by 64 percentage points over the three-year period ended April 30, 2006. ² At that point, the concept of diversification and of not having a portfolio concentrated in U.S. assets remarkably became a much easier conversation.
However, as the chart above clearly shows, the current outperformance of U.S. stocks will likely not last. Diversifying between U.S. and international equities and between U.S. and international hedged fixed income gives you the chance to participate in whatever region or asset class is outperforming at the time. Because U.S. and international markets may perform differently—at times, very differently—a global portfolio may provide smoother performance over the long term than a portfolio invested wholly in one region or the other.
Tomorrow is a new day
As the chart shows, there has been no consistent “winner,” and thus, although enticing, performance-chasing is typically unsuccessful. Whether moving in or out of individual funds, market sectors, or geographic regions, investors who make reactive decisions based on recent performance rarely achieve the results they intend. Likewise for those who believe they know what lies ahead.
As recently as a year and a half ago, many investors showed a reluctance to consider globally diversifying to international hedged fixed income as global yields dropped (and were negative in some countries), in fear that performance relative to U.S. fixed income would suffer. But in the 19 months ended September 30, 2016, international hedged fixed income outperformed not only the U.S. fixed income market but the U.S. and international equity markets as well!
Long term, not short term
It’s important to note that as correlations between U.S. and non-U.S. financial markets change, the impact of diversification can change as well. But let’s not forget that the value of international diversification is more than just understanding that the U.S. and international markets alternate top performance. The amount of international exposure should always be based upon the long-term diversification benefit rather than recent short-term outperformance.
The expectation is that the long-term returns of non-U.S. assets should be similar to the long-term returns of U.S. assets, which means the diversification benefit really comes from a reduction in volatility without a discount in long-term expected return. That is, diversifying globally can mean smoother performance over time.
My life is much richer because of the travels I’ve taken. While we don’t know what the future holds, I imagine our investing journeys will be better off, too, by experiencing what lies beyond our borders.
1For the three years ended December 31, 1997, U.S. stocks, as represented by the Dow Jones Wilshire 5000 Index, returned a cumulative 117%, and international stocks, as represented by the MSCI World ex US Index through April 30, 1995, and the MSCI All Country World ex USA Index thereafter, returned a cumulative 15%.
2For the three years ended April 30, 2006, U.S. stocks, as represented by the Dow Jones Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad Market Index thereafter, returned a cumulative 60%, and international stocks, as represented by the MSCI All Country World ex USA Index, returned a cumulative 124%.
- All investments are subject to risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss.
- Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates.
Scott Donaldson, CFA, CFP®, is a senior investment strategist in Vanguard Investment Strategy Group, Vanguard’s global team responsible for developing the firm's investment methodology as well as for publishing proprietary research on a variety of investment, economic, and portfolio management issues. He leads a group responsible for capital markets research and the asset allocations used in Vanguard's fund-of-fund solutions, such as Vanguard Target Retirement Funds. Mr. Donaldson's group maintains and enhances the investment methodology used for advice-based relationships with high-net-worth, institutional, and financial advisor clients. He also regularly serves as an ambassador for Vanguard, speaking at client events and industry conferences on a range of investment topics. Previously, Mr. Donaldson served as an investment manager for clients of Vanguard Asset Management Services™. He has 25 years of experience in the investment management industry and earned an M.B.A. from Saint Joseph's University.
CFA® is a registered trademark owned by CFA Institute.
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Investments in bond funds are subject to interest rate, credit, and inflation risk.
Diversification does not ensure a profit or protect against a loss in a declining market.
Foreign investing involves additional risks including currency fluctuations and political uncertainty.
Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.
All investing is subject to risk, including possible loss of principal.