revisiting the benefits of
international diversification


June 30, 2023

One of our core investing tenets at The Mather Group, LLC (TMG) is diversification. Given that international stocks comprise about 40% of the world’s stock market capitalization,1 we believe that investors who focus only on the U.S. are missing an opportunity to increase long-term returns and reduce risk. This article highlights research and analysis to illustrate the benefits of maintaining a well-diversified portfolio that includes international investments.

A common critique of international diversification is that many U.S. companies also have sizable revenues from overseas since foreigners buy our goods. While true to an extent, we believe that these multinational companies are not a replacement for the diversification achieved by investing in foreign companies. In addition, U.S.-based multinational companies tend to be concentrated in sectors like technology and tend to be larger companies. Due to this sector concentration and tilt toward larger companies, a portfolio of only domestic stocks may be underinvested in smaller-cap companies and other sectors that provide greater diversification.

The run of U.S. outperformance over the last 15 years also causes many investors to question the benefits of a global portfolio. However, markets move in cycles, and the U.S. market has not always outperformed. As the table below illustrates, U.S. stocks and international stocks have each had periods of outperformance. Looking back to 2022, it is possible that a new period of outperformance could be starting for international stocks.

Another reason to own international stocks, and a potential catalyst for outperformance, is that price-to-earnings (P/E) ratios, a measure of valuation, are more attractive overseas. Even more powerful, the chart below shows that profitability levels (return on equity, or ROE) overseas are approaching U.S. levels, while international stocks are also trading at historical discounts to the U.S.2 Framed another way, if you want to buy a stock with higher profitability (ROE of 15-20%), it seems attractive to pay less for a dollar of earnings, comparing the P/E of 7.6 in Emerging Market Latin America to the 17.8 P/E in the U.S.

Furthermore, looking at the stocks that have been driving the S&P 500 (see table below), they are arguably extended from a valuation perspective, given that the trailing 12-month (TTM) P/E ratio for the S&P 500 was 24.7 as of 6/26/23 and the S&P 500’s historical average TTM P/E is 17.8.3 These relatively high valuations increase risk going forward.

As always, we must reiterate that valuations aren’t dependable from a timing standpoint, but they have held predictive power for long-term returns. To elaborate, buying inexpensive investments doesn’t mean that they will instantly pay off, or even multiply in value over the next few years. After all, the market is fickle. But over longer periods of time, less expensive holdings tend to do well, while expensive investments tend to face headwinds.

Based on the above data, not only does an international stock allocation lower the risk of missing out on returns over the long term, but an allocation aligned with the world market weight has also shown an ability to reduce the volatility of a portfolio overall, while maintaining similar upside potential (see chart below).

Of course, many other factors affect global diversification. For example, there has been a shift towards deglobalization as countries revert to manufacturing domestically. This helps them reduce dependence on other countries and may create more competition, instead of one multinational company dominating an industry. With countries and companies becoming less intertwined, and most of the world’s consumers being outside the U.S., the case for international diversification is strengthened. This is clearly a trend that will be monitored for years to come.

Geopolitical issues are other potential factors driving investment returns, but they surprisingly don’t always create the results we’d expect. While disruptive from an economic and humanitarian standpoint, the Russian invasion of Ukraine was expected to be a major headwind to international returns, but as shown in the “International v. U.S. Return Cycles” table above, it did not prevent developed international stocks from outperforming U.S. stocks.

Currency returns also affect stock market performance, and the strength of the dollar has been a headwind for international returns, as shown in the chart below. If this dollar strength abates, that could also be a profitable tailwind for international returns.