What follows is a hypothetical conversation between two fictional investment professionals, Bob Smith, based in the United States, and his colleague Sandra Mueller, who works in Frankfurt.
Their subject: investment in international equities and diversification.
Bob Smith: Hi Sandra. Ho are you doing?
Sandra Muller: Hi Bob. Thanks very much. Everything is fine here in Germany.
When we last spoke, we started discussing international equity investing from an American perspective. The world has certainly changed and continues to do so, and there are certainly pros and cons to consider. So I did some research and analysis that I would like to share with you.
Excellent. I did too.
What did you imagine?
So I looked at the S&P 500 for US stocks and the MSCI EAFE and Emerging Market (EM) indices. I chose these two rather than the MSCI ACWI ex US in order to have a more nuanced view of the international scene. The time period I focused on is 1988 to 2020, which I think sums up a lot.
And what did you find?
Well, starting with returns, as we all know, the United States has done very well over the past 10 years. Before that, results were mixed, but in the long run, the S&P won the race, beating emerging markets and destroying the EAFE index.
The graph below shows the cumulative performance over the period.
Cumulative performance of the index
Yes, the S&P has had a great run, while Emerging Markets and EAFE have led nowhere over the past decade. In fact, the performance of the EAFE has been really disappointing for a long time.
But return is only part of the big picture, so as agreed, I analyzed risk and correlations. While the case for international investing looks weak on the basis of returns, it gets even worse when you factor risk into the equation. I calculated the standard deviations of the returns for the years 1990, 2000 and 2010 and plotted them with the returns of the three indices.
Here is what I have:
Annualized returns and standard deviations, 1990s to 2010
As you noted, the United States performed better. But he also had fewer risks. It’s “win-win” as you say. And as we discussed last time, correlations have increased over time, limiting the benefits of diversification. The correlations were around 0.55 for EAFE and EM in the 1990s, but have now increased to around 0.85 for EAFE and 0.75 for EM over the past decade.
So is that what they’re referring to when they say “diworsification”?
Speaking of diversification, I’ve plotted the monthly returns of the three indices for the 33-year period. I think when people talk about diversification, they’re really concerned that their foreign allocations are protecting them when US returns are negative. Thus, the graph below plots 396 months each for the S&P 500 and MSCI EAFE indices on the one hand and for the S&P 500 and MSCI EM indices on the other.
I don’t think anyone is overly concerned when US and foreign investments perform positively or even when one has positive returns and the other negative. I guess that’s diversification. But it’s another matter when they both malfunction.
See the “disappointment” quadrant in the table below. Over the 33 years, the S&P has recorded 143 losing months, or 36% of the total. The EAFE index also lost in 55 of those months and the EM index in 53. The average loss for the S&P was 3.5%, but the average for the EAFE was 4.3% and l ‘EM was 4.5%, which contributed to investor disappointment.
S&P 500 vs. MSCI EAFE and MSCI EM, monthly return, 1988 to 2020
Based on the evidence, you should say it doesn’t look good for investing outside of the US. Maybe you should keep all your money at home, Bob.
I know. You would think so. Have you ever heard of “Acres of Diamonds”, the speech of Russell Conwell, the founder of Temple University? Conwell recalls a parable which teaches that there are plenty of diamonds in your own backyard and you need not go any further to look for them, potentially in vain. It makes sense with the big beaters in the tech world that we have here in the United States.
TRUE. But remember: there is only water under the bridges. We must always look to the future. And even though the United States accounts for almost 60% of global stock markets, there is still 40%.
And the United States represents only a quarter of the world’s GDP and has only 4% of the world’s population. Other parts of the globe have much higher growth and there’s a lot of innovation in artificial intelligence and electric vehicles and so on elsewhere. Don’t want to be part of it?
I hear you. I guess we never know what’s going to happen. We should aim to invest globally all the time and have at least a small allocation to international markets.
Exactly! The bottom line is that even though international, developed and emerging markets have generated less returns with more risk and higher correlations, as prudent investors we must remain confident in diversification because no one knows what tomorrow reserve for us.
LAW! That’s great, Sandra. Thanks for your help. We’ll talk soon. Take care of yourself.
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Photo credit: ©Getty Images/ Yuichiro Chino
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their HGV tracker online.