A long-standing tenet of investing holds that, to earn a higher investment return, one must be willing to embrace a higher degree of risk. And, historically, small-cap stocks have had greater returns compared to their large-cap counterparts, but have carried a higher level of volatility.
International stocks, meanwhile, have typically been more volatile than U.S. stocks, presenting investors with another equity category to navigate. That long-standing tenet of investing was challenged by groundbreaking work released in 1952 by Harry Markowitz, who introduced the concept of modern portfolio theory (MPT).
MPT, which won Markowitz the Nobel Prize in economics, holds that while individual assets may be highly volatile, multiple assets blended together make it possible to construct a portfolio with relatively high returns and reduced volatility.
This can be achieved by blending assets that are not markedly correlated. If two assets have a perfect correlation, meaning that they produce the same return with the same level of volatility, they have a correlation of one. Conversely, if two assets have a correlation of zero, they have no connection whatsoever. Assets with a low correlation are likely to perform in a different manner over time with varied reactions to market news and economic indicators.
An increased investment could act as a much-needed diversifier to your portfolio.
Portfolios as a whole will naturally stray from their initial allocation, as the better performing asset classes grow into a larger percentage of the total. Since their lows in 2009, U.S. markets have significantly outperformed international markets, by a factor greater than two to one.
A diversified portfolio from 2009 which had not been rebalanced by the end of 2016 would have become heavily weighted toward U.S. stocks, versus its initial allocation. The portfolio’s owner would have welcomed that development, as the Standard & Poor’s 500 index returned 11.96 percent in 2016, while the MCSI Europe, Australasia and Far East (EAFE) index returned a mere 1.00 percent.
Of course, there have been many periods when international equity returns exceeded those of domestic equities. However, it is unusual to have an eight-year run of U.S. equity dominance. This can be attributed to the United States rebounding from the Great Recession faster than expected, and the dollar having been stronger than most international currencies.
By most financial metrics, domestic stocks have reached loftier valuations relative to their international peers. The domestic equity markets are trading at a price-earnings multiple of 18, while the international markets are trading at a multiple of 12. This differential has begun to be reflected in performance, as the return on the S&P 500 was 11.93 percent through August 31, 2017, versus an EAFE return of 17.05 percent.
The MSCI Emerging Markets index, representing the smallest economies in the world, is now actually leading the pack, at 28.29 percent.
So, how can you take advantage of these developments? For one thing, you can invest in a variety of ways internationally. There are countless exchange-traded funds, actively managed mutual funds and index mutual funds in that category.
At Sterling, we prefer not to buy broad international index funds, as they own interests in the entire market. This includes certain industries, such as European banks, that we would rather not incorporate into our portfolios. Instead, we seek actively managed international equity mutual funds, put through rigorous vetting, to complement our individual stock selections.
Overall, quality portfolio oversight requires a periodic review of asset allocation, and a subsequent rebalancing. This fall may be an opportune time, for instance, to evaluate your own international exposure. Foreign equities have become underweighted over the last decade, so an increased investment could act as a much-needed diversifier to your portfolio.