Why Invest Abroad?

The United States’ market has outperformed other developed countries’ stock markets for the past five years. The dollar has risen relative to other currencies, meaning that the dollar-denominated performance of international equities has paled in comparison to that of the S&P 500.

Figure 1: One-Year, Three-Year, and Five-Year Performance of U.S. Market vs. Major Developed Market Equity Indices, in local currency and in dollars through Q3 2016

Source: CapitalIQ

The dollar’s gain in the fourth quarter of 2016, after the election of Donald Trump, has caused this trend to continue.

Figure 2: Q4 2016 Performance of U.S. vs. Major Developed Market Equity Indices, in local currency and in dollars

Source: CapitalIQ

The outperformance of the U.S. markets has persisted long enough that some might be tempted to assume it as a general rule — that the market has recently revealed a longer-term truth. It’s seductively easy to come up with arguments as to why this trend should persist.

But we do not believe that trend extrapolation is an effective way to predict the future. Rather, we prefer base rate forecasts. Nor do we think that the strength of the U.S. market over the past five years is reason to eschew international diversification, particularly when foreign markets account for more than 50% of global equity market capitalization.

The base rate statistics supporting international diversification are strong. Over longer-term periods, the United States’ outperformance of international markets has been a coin flip.

Figure 3: Trailing 12-Month Return Differential between U.S. and non-U.S. Stocks

Source: Vanguard "Global Equities: Balancing Home Bias and Diversification"

Adding foreign stocks to the portfolio has historically reduced volatility in addition to improving returns.

Figure 4: Volatility Reduction from International Diversification

Source: Vanguard "Global Equities: Balancing Home Bias and Diversification"

A large percentage of U.S. outperformance has come recently from a strong dollar, and investors might be tempted to say “fine, put some money in foreign stocks but at least hedge the currency.” But base rates would suggest that over the longer-period there’s no strong reason to hedge currencies.

Historically, currency movements have been uncorrelated to stock market performance, enhancing the diversification benefits of investing abroad. And for every year the USD has outperformed international currencies, there has been another in which the USD has underperformed.

Figure 5: Annualized Contribution of USD to Non-U.S. Equity Returns

Source: Vanguard "Global Equities: Balancing Home Bias and Diversification"

The message from history is clear: international diversification, with no currency hedging, will be a long-term benefit to your portfolio, both in reducing volatility and in enhancing returns. Trend extrapolation and chasing returns are not reason enough to cast aside the base rates of history. After a long stretch of USD strength and U.S. stock market outperformance, we believe it’s time for investors to look abroad for opportunities, especially to the cheapest of the developed markets: Japan.