I’ve had a few questions from my clients about why we own international stocks when they are underperforming U.S. stocks. For those clients who started in 2008 or later, you probably do not remember the time when international stock returns were much higher than U.S. stock returns. I have included a chart from our January 2008 quarterly letter that shows how different international returns were during the 1, 5, and 10 year periods that ended on December 31, 2007. The 1 year returns in 2007 show international large stocks beating the S&P 12.46% to 5.49%, as well as international large value stocks killing U.S. large value stocks 10.24% to -2.76%. The other international classes handily beat their corresponding U.S. asset classes in 2007, and Emerging Markets earned 36.02%! If you look at the 5 and 10 year returns (ending in 2007), the international asset classes also did much better than their U.S. counterparts by anywhere from 8% to 11% annually over 5 years and 3% to 5% annually over 10 years. Those of you who started with me in 2001-2005 remember those early years and how important the international markets were for your portfolios. Emerging Markets had a 16% annual return from 1997-2007, and it still has a strong 10 year return of 8.55% from 2004-2014. In fact, there have been many periods where international markets have done well, as well as periods where they did not. The same goes for every asset class that we invest in, including U.S. stocks and real estate.
The reason we diversify is because we do not know what areas of the market will do well in the near term. We must consider the long term history—not just the last 5 or 10 years—when thinking about asset allocation. Just because the international markets have not performed well in 2014 or during the last 5 or 10 years, it does not mean they will not do well in the coming years. We own all of the major asset classes (U.S. stocks, real estate, international stocks, and emerging markets) because we do not know how each will do in the short term. Therefore, we are spreading the risk equally over each area. We know that over long periods of time (15-20 years), each of these assets classes will contribute to a strong annual return. Diversification also allows us to buy asset classes as they drop and sell them when they go up, which increases our returns. While it may be tempting to only invest in the areas that have done well recently, this is a huge mistake because the future IS NOT predictable in the short term. If you limit your investments to just the U.S. markets, and they have a terrible 15 year period (such as 1966-1980, when the S&P earned a 0% real return), then your entire portfolio would be hit hard and may never recover. On the other hand, a diversified portfolio usually owns the asset classes that have gone up, as well as the asset classes that have gone down. Over the long term, rebalancing will lead to higher portfolio returns than you could otherwise achieve by just owning the U.S. markets. It is my professional opinion, based on a thorough review of 90 years of historical returns, that we should invest broadly across all of the major equity asset classes, no matter how they have performed in the recent past.
About Christopher Jones
Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.
