The Historical Imperative for International Diversification
I’ve been getting lots of questions about the benefits of international diversification. The questions are variations of “Why do I want to own these poorly performing investments that also create currency risk?”
Among the two most well-documented investment biases are home country (leading to dramatically overweighting one’s home country relative to global market capitalization) and recency (leading to performance chasing – buying what has outperformed at relatively high prices and selling what has underperformed at relatively low prices). Having a knowledge of history, and understanding that when it comes to all risky assets, even a decade of underperformance is likely nothing more than noise, can help overcome such biases. With that in mind, let’s go to my trusty videotape.
If you asked most investors about the long-term relative performance of U.K. and U.S. stocks, they would assume that U.S. stocks would have far outperformed. Recency bias, and the collapse of the pound sterling in the post-WWII era, would be a contributor to that belief. From 2009 through 2018, the S&P 500 Index outperformed the FTSE All-Share Index by 5.3 percentage points per annum (13.1% versus 7.8%, respectively). And the outperformance is much greater over the last five calendar years (2014-2018), with the S&P 500 outperforming by 9.7% per annum (8.5% versus -1.2%).
Now let’s take a trip back in time to a decade ago and look at the long-term performance. The FTSE data goes back to February 1955, so we will use that as our starting point. From February 1955 through December 2008, the FTSE returned 10.4% per annum, outperforming the S&P 500 Index’s return of 9.7% per annum by 0.7%age points. Even through 2013, the outperformance was still 0.7 percentage points per year (11.0 versus 10.3). That’s almost 60 years of outperformance. What conclusions would you have drawn? If we extend the data through 2018, the S&P 500’s advantage is small: 10.2% versus 10.0%. The slight underperformance occurred while the pound was falling from $2.80 to about $1.26, a drop of 55%!
Investors should not allow relatively short periods of outperformance to influence long-term investment strategies. Nor should they allow home country bias to lead to under-diversification of their portfolio. We have one more important point to cover.