The Importance of International Diversification

International diversification

With a seemingly constant drip of bad news from around the globe—military conflicts in Eastern Europe and the Middle East, the spread of Ebola, slowing economic growth in Western Europe and many emerging markets—it may feel that the US is the only safe place to invest your money. But not having enough exposure outside the US means not enough diversification, and that can actually mean higher risk and potentially lower returns over the long run.

The performance of international stocks is driven by some of the same factors that affect US stocks. An upturn or downturn in the global economy, for example, may have an impact on stocks from all countries. But there are plenty of other things that can affect stocks in some countries but not others, such as different valuations, different economic growth rates, different demographics, and different political environments.

These differences mean that international stocks often don’t move in lockstep with US stocks. US stocks substantially outperformed international stocks in 2013, for example, but actually underperformed in 2012 despite the economic woes of the euro zone. Having exposure to both the US and to international markets therefore can mean fewer large ups and downs for your entire portfolio.

Despite overseas wars and economic weakness abroad, the benefits of a globally diversified portfolio may become even more apparent in the coming years. As we’ve noted before, US stocks currently appear to be slightly overvalued by historical standards. This fact doesn’t necessarily mean that US stocks will do poorly, but it increases the chances that their future returns will be below average.

Valuations on international stocks, by contrast, appear to be more in line with historical norms. Strategists at Research Affiliates project that over the next 10 years, current valuations will reduce the returns on US stocks by an average of 1.5% per year. For international developed stocks they think this number will only be 0.6% per year, and for emerging market stocks they think current valuations will actually increase returns by an average of 0.4% per year. Not having enough international exposure, in other words, could mean more risk and less reward.

Topics: Blog Stock Market International Valuation Diversification