Does Diversification Still Work?

US stocks posted a strong year in 2016 hitting record highs after the election and gaining 12.74%. International stocks followed a similar trajectory as US Stocks for the first half of the year, however after the Brexit vote the two diverged and then split further after the US election results.  International stocks posted a 5.12% return for the year.  It marks the fourth straight year that US stocks have outpaced foreign stocks and the fifth time over the past six years.

You might begin to wonder if investing internationally still makes sense? To that question we respond with a resounding yes.  It’s important to remember that investing internationally provides valuable diversification benefits and that recent performance is not a reliable indicator of future returns.

International equity markets represent nearly 50% of the global equity market with more than 10,000 companies in more than 40 countries. By not including international equity in a portfolio an investor would not be exposed to the performance of those markets.

While investing internationally certainly has not worked out in recent years you don’t have to look that far back historically to see international markets in favor.

intl-vs-us-returns-2000-2009

From January 2000 to December 2009, an entire decade, US stocks fell. Over this time period international stocks rose by a cumulative 25% more.  Also, areas we emphasize, small cap, value and emerging markets, performed much better by comparison.  Looking back to 1900, international markets outpaced US markets in six of the eleven decades through 2010.  By not exposing a portfolio to international markets an investor misses out on the potential for these superior returns.

If you think that the best performing countries can be identified beforehand the following exhibit shows how much it changes from year to year and the difficulty in identifying which countries will be the best in any given year. The below chart shows the historical returns for 19 different developed market countries over the past 20 years.

country-returns

(Click to enlarge)

There are significant swings from year to year in what countries are the best and individual countries can also vary widely. The average return of the best performing developed market country has been 37.5% over this time, while the worst performing developed country was down 17.5%.  By just focusing on one country it exposes a portfolio to large swings in performance.

While trailing recently, international equity has shown historically that there are many periods when it has outperformed US stocks. Also, by investing internationally it has the potential to reduce portfolio volatility by exposing a portfolio to markets that are performing quite differently over shorter time periods.  Thus, by investing across the total global equity market a portfolio can provide diversification benefits.

 

Index Performance    Dec. QTD YTD
US Stock (Russell 3000) 1.95% 4.21% 12.74%
Foreign Stock (FTSE AW ex US) 2.74% -0.99% 5.12%
Total US Bond Mkt. (BarCap Aggregate) 0.14% -2.98% 2.65%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) 0.01% -1.14% 1.02%
Municipal Bonds (BarCap 1-10yr Muni) 0.72% -2.62% -0.10%
Cash (ML 3Month T-Bill)  0.04% 0.09% 0.33%

 

About

Raffa Wealth Management is an independent investment advisor providing nonprofit organizations, high net-worth investors, and qualified retirement plans with a full range of investment consulting services.  We were established to fill the need for transparency, clarity, and vision in the professional management of investment assets.   Visit us at www.raffawealth.com

 

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