For much of the 1990s, the U.S. stock market significantly outperformed international stock markets. Never a particularly large percentage of U.S. investment portfolios, international investments drew even less attention during this time. Is now the time to take another look at international investments? Before deciding, consider the following:
Return potential. During the 1990s, the U.S. stock market clearly outperformed international stocks. But that was not always the case – international markets outperformed U.S. stocks during the 1980s. A study of 10-year annualized returns for the Standard & Poor’s 500 (S&P 500) and the Europe, Australasia, and Far East (EAFE) index from 1970 to 2000 found that the EAFE outperformed the S&P 500 in 15 of those 21 periods (Source: AAII Journal, October 2001).*
After U.S. markets dominated in the 1990s, are international investments set to start outperforming? While no one knows for sure, there may now be opportunities to find investments in other parts of the world that are more attractively priced than those in the U.S.
Diversification. One of the primary advantages cited for international investing is to reduce the volatility in a portfolio through diversification. The theory is that when the U.S. stock market is declining, investments in other parts of the world may counter that trend. Recently, however, it appears that during periods of crisis, stock markets throughout the world have moved in the same general direction. How accurate is this assessment?
One way to measure the benefits of diversification is to look at the correlation of two asset classes. A positive correlation means that the prices of the two assets move in the same direction. A correlation of +1 indicates that the assets move together very closely in the same direction. A correlation of -1 indicates that the assets move in opposite directions. A correlation close to 0 means that there is no relationship in the price movements of the two assets. The lower the positive correlation or the higher the negative correlation, the more risk that will potentially be eliminated. Typically, asset classes are considered to have good diversification benefits if they have correlations of 0.6 or less.
Until recently, the correlation between the U.S. stock market and the EAFE was 0.5 or less (Source: AAII Journal, October 2001). As of early 2001, however, that correlation had increased to 0.75 (Source: Money, September 2001). While that reduces the diversification benefits, it remains to be seen whether the correlation stays at these higher levels or comes down to more historical levels.
Also keep in mind that the correlations listed above relate to foreign stock markets overall. The correlation between the U.S. stock market and specific foreign stock markets can be significantly different. For instance, historical correlations between the U.S. and Canadian stock markets are higher than 0.7, while the U.S. and Japanese correlation is 0.3. Emerging markets typically have a low correlation with the U.S. stock market (Source: AAII Journal, October 2001).
Currency fluctuations. When considering international investing, make sure you understand the significant role of currency fluctuations. Your return from an international investment is comprised of two components: the investment’s return in local dollars and the impact of any currency fluctuations. Part of the reason U.S. investments dominated in the 1990s was due to the strong U.S. dollar. Now, the U.S. dollar is starting to show some weakness against other currencies, which could bolster the returns of foreign investments.
Investment opportunities. The U.S. stock market now represents only slightly more than 50 percent of the total market capitalization of the world (Source: Reuters Business Report, February 20, 2002). Limiting yourself to U.S. stock investments means eliminating nearly half of the world’s investments from consideration. In a number of industries, the world’s leading companies are not U.S.-based companies. International investing is increasingly moving from a methodology of selecting regions of the world to invest in to selecting stocks of leading companies, no matter where they are based.
For all these reasons, now may be a good time to take another look at international investing. Keep in mind, however, that international investments may not be suitable for everyone. In addition to the risks associated with domestic investing, foreign investing has unique risks, such as currency fluctuations, political and social changes, and greater share price volatility.
* Note: The S&P 500 is an unmanaged weighted index generally considered representative of the U.S. stock market. The EAFE is an unmanaged index of 1,000 foreign stocks generally considered representative of stock markets outside the U.S. Investors cannot directly purchase an index. Past performance is not a guarantee of future results. This information is presented for illustrative purposes only.