International stocks still offer diversification benefits

A long-held axiom among professional investors says that diversifying a portfolio by adding international stocks helps to reduce risk and enhance returns. But as the world’s developed economies in Asia and Europe have become more tightly entwined, critics have argued that global investing’s allure has declined because stock market patterns in major markets have converged.

Rex Sinquefield, who helped develop the first long-term analysis of stock market returns, concluded in 1996 that these arguments were both right and wrong. He demonstrated that the returns on large stocks in Europe, Asia, and the United States had coalesced, after discounting the effects of local currency fluctuations. However, he still found some diversification benefit because there is enough difference in return patterns between markets that investing in several at once helps to reduce volatility (for instance, Japan’s market may be rising during a year when Germany’s is falling). Sinquefield’s big conclusion, however, was that investors can get a lot of diversification and return bang for their bucks by concentrating in international small stocks and international value stocks.

Professors Eugene Fama and Kenneth French had already demonstrated in the early 1990s that stocks of small companies and so-called value stocks (those whose prices were low in relation to their company’s book values) offered high returns and diversification benefits in the United States. Sinquefield, Fama, and French argued that the phenomenon was international as well.

An update of Sinquefield’s work by Dimensional Fund Advisors, the firm he founded, has provided support for this theory. Since 1970, the annual average returns of small and value stocks both here and abroad have exceeded large stocks by anywhere from three to six percentage points. However, small and value stocks also are more volatile than large stocks. For that reason, investors should maintain modest allocations to the risky asset classes in order to improve their returns without adding additional overall risk, DFA says.