Don’t Forget International Stocks

I received a question from a long-time reader, noting the multi-year underperformance of non-US stocks relative to US stocks. 

Over a 10-year interval, he noted, international stocks very rarely outperformed US stocks, and concluded that it “makes me wonder why any asset manager would invest more than a token amount in international stocks, funds, or ETFs.”

I wildly disagree with his conclusion, but it is a great question. What exactly is the point of investing in international stocks, especially those that just seem to do worse than US stocks over a decade?

To begin, can we nerd-out for a moment on portfolio theory? We start with the first principle that we choose assets because they offer a return. But unfortunately, they also carry some risk.

Stars_and_stripes

Patriotism is not a good portfolio reason to own only American

As a second principle, we also assume that we want to maximize returns, while minimizing risk. More returns = good. More risk = bad. 

Portfolio theory says that you can accomplish the goal – more returns and lower risk – by owning more than one investment.

If you have two (or more) investments (or mutual funds, in our analysis) that are not perfectly correlated, then portfolio theory says that you improve your combination of risk and return – as a combination, as a portfolio – when you combine these two (or more) assets.

The key ingredient to this recipe working is non-correlation between the investments. In non-technical terms, when one asset zigs, the other one zags. Underperformance during some period of time with one asset will be offset and blended with outperformance of the other asset.

When you combine a US-based mutual fund with an international-based mutual fund, portfolio theory does not promise you better returns. Instead, it promises that the combination will, over time, get you closer to the maximum return on your portfolio for a given level of blended portfolio risk. 

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