U.S. stocks’ performance so far this year offers a perfect illustration of why investors should not exaggerate the benefits of international diversification.
When the U.S. stock market plunged more than 10% in late January and early February, for example, international stocks lost even more. Far from cushioning the fall for investors, they made things slightly worse.
When the U.S. stock market again fell sharply, between Mar. 9 and Apr. 2, international stocks also fell. Though this time they didn’t fall as much as U.S. equities, the cushion they did provide was scant comfort.
In both cases, international diversification did not live up to its advance billing as providing a “free lunch” of reducing portfolio volatility while forfeiting very little return in the process.
To be sure, these two instances by themselves add up to little more than anecdotal evidence. But it turns out that, historically, what happened in these cases is more the rule than the exception.
What then accounts for the “free lunch” narrative that is widely associated with international diversification? Because, on paper, such diversification is supposed to work a lot better: Even though international stocks exhibit relatively little correlation with domestic stocks, their return over the long term is quite similar. A portfolio divided equally between domestic and international stocks should therefore produce the same return as a domestic-only portfolio but with significantly less volatility.
The key word is “should.”
The problem is that the correlation between domestic and international stocks is not constant. It instead shifts with the bull and bear cycle of the market itself: The correlation is lowest when the U.S. market is rising, and highest when U.S. equities are falling.
As a result, international stocks provide the least diversification precisely when investors need it most — when U.S. stocks are declining. And when U.S. stocks are rising, and investors don’t need or want any diversification, international stocks provide it in spades.
To be sure, this analysis doesn’t mean that there are no diversification benefits to diversifying your equity portfolio between U.S. and non-U.S. stocks. It’s just that those benefits are significantly lower than what many experts claim.
The investment implication: Equities are risky, regardless of whether they are of domestic or foreign companies. This is important to remember, especially if your equity allocation is greater than it would be otherwise in the belief that diversification will reduce that risk.
What you don’t want to do is wait until the next bear market and discover — too late — that diversification didn’t protect you to the extent you had hoped it would. That’s what happened during the Great Recession: the U.S. stock market lost 55.5% (as judged by the Vanguard Total Stock Market ETF VTI, -0.07% ) and foreign stocks lost even more — 60.3% (as judged by the Vanguard Total International Stock Market Index Fund VGTSX, -0.53% ).
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .
