Are US Stocks Enough For Your Portfolio? (EP.107)

0:28We all need to make smart decisions with our money. attractive to many other places in the world. We also have the majority of the biggest and best companies in the world. And when you look at long-term historical returns, U.S. stocks have outpaced developed international stocks by over a full percentage point per year. Which begs the question, does it even make sense to own international stocks? Two iconic investors, Warren Buffett and Jack Bogle, have publicly argued against it. Warren Buffett says an index portfolio of 90 % S &P 500 and 10 % treasuries is probably good enough for most investors, while Jack Bogle argues that U.S.

1:11large-cap stocks derive plenty of their revenue from overseas, and as a result, international stocks aren't necessary. Of course, quotes from these two investment icons are regularly taken out of context. Neither pretend this is evidence-based advice, and at different times, both have admitted that the advice is geared to investors who need to keep it simple due to their level of assets, education, or resources, rather than those who want to generate the highest returns for the lowest risk. And aside from these two investment legends, basically everyone else agrees that the diversification benefits of owning a global portfolio of stocks are reason enough to do so.

1:55That said, the way diversification shows up on performance statements makes it challenging to appreciate its benefits. So rather than going through the mathematical benefits of diversification as I have in the past, here in this episode, I'm going to focus almost exclusively on relative performance of U.S. versus international stocks. Almost a decade ago, I wrote a piece for the CFA Institute assessing an allocation to global stocks that compared U.S. stock returns to the MSCI World X-U.S. Index, which tracks the returns of developed international countries. Now, I normally use the MSCI All-Country World X-U.S.

2:37Index when talking about the performance of non-U.S. stocks because it includes both developed and emerging markets, but that data set only goes back to the 1990s, whereas the MSCI World X US goes back to 1970. And in that article, which I will link to in the show notes, there were clearly times when international stocks did better, specifically the 70s, the 80s, and the 2000s. And there were other times when US stocks did better, like the 90s and the 2010s. But looking at the entire data set from 1970 to May 2023, U.S. stocks have outperformed by 1.6 percentage points per year. But the entire data set didn't always look this way.

3:21Had we made this comparison at the end of 2010, U.S. stocks historically trailed international stocks. And I can clearly recall my conversations with investors at the time, it seemed as if everyone wanted to know, why didn't we hold more non-US stocks, particularly emerging markets? And it's funny how historical returns, particularly recent returns, tend to influence investors' expectations for an asset class. But that's exactly what has caused and will always cause investors with a diversified portfolio to question the portion of that portfolio that is currently losing. Because remember, and this is my last note on diversification, I swear, being diversified by definition means that you must always own the losers.

4:11There's no way to be diversified and only own the winners. Now back to performance, there was a paper published last month in the Journal of Portfolio Management that dives deeper into the recent outperformance of U.S. stocks versus developed international stocks. An important piece of understanding the author's findings are the drivers of return. In any given year or time period, you can attribute asset class or even individual stock returns to three things. The first, changes in earnings per share. The second, changes in cash paid to shareholders, whether that's dividends or buybacks. And the third, changes in valuations.

4:52In the Journal of Portfolio Management article analyzing these recent outperformance trends of U.S. stocks, the authors found that the primary driver was changes in valuation. In other words, U.S. stock outperformance was largely attributable to it getting more expensive. Now, outperformance driven by superior fundamentals such as earnings and cash paid to shareholders may or may not be repeatable. But winning because people were simply willing to pay more for the same fundamentals is likely not repeatable. And if anything, valuations have a slight tendency to mean revert, particularly when they are at extreme levels as they are today.

5:35So what does that all mean? here's the important takeaway from that article when thinking about returns going forward. Research has shown that countries selling at lower valuations should have a higher long-term expected return. Now, to this point, I've been talking exclusively from a passive index investor perspective, but investors applying a factor approach have seen different results. In the show notes at thelongterminvestor.com, I'm going to include a table that I regularly update for clients comparing the performance of different asset classes over the last 10 years, the prior 10 years, and the full 20-year period.

6:15In the table, U.S. large cap is represented by the S &P 500. You'll also notice a line item for the MSCI All-Country World Index, which is a market cap-weighted index for the total world markets, including the U.S., developed international, and emerging markets. And then there's a line item for Global Factor Portfolio, which tracks the Dimensional Equity Balance Strategy Index, a factor-based index with notable exposures to value, size, and profitability factors. I think this table does a really nice job of letting you see how the winners differ from one decade to the next, but the consistent winner across all periods is a globally diversified, factor-tilted portfolio.

6:59One final benefit I'd like to point out when talking about international stocks is their performance during periods of low returns in the U.S. According to a BlackRock study from 1973 through 2022 that I will include in the show notes, international stocks outperformed U.S. stocks 96 % of the time when U.S. stock returns were less than 6%. And when U.S. returns were less than 4%, international outperformed 100 % of the time. We don't know what the future holds for U.S. or international returns, but let me share one more input, this time from Vanguard. Vanguard regularly publishes 10-year annualized return and volatility forecasts based on the running of their capital markets model using a two-point range around the 50th percentile of the distribution from probable outcomes.

7:51Now, I'll obviously provide a link to these numbers in the show notes, but let me just call out one return projection they have for U.S. equities, and it is for the next 10 years to average returns between 4.1 % and 6.1%. Again, these are just model predictions, but I'm open to appealing to the market timer in you if that's what it takes, because Vanguard's projections paired with BlackRock's historical data showing International's outperformance over the U.S. when returns are less than 4 % or 6%, that should at a minimum give you a second thought about an all-U.S. stock portfolio at least at this point in time.

8:31Look, I think owning international stocks still makes a ton of sense. And as I said at the beginning of the episode and in many past articles on the topic, the primary case for owning international stocks is about diversification. But I get it. Diversification in action in the moment is pretty tough to live through. And there's a full generation of investors who've seen international diversification drag down returns, but the long term case for it remains really strong. Not only does financial theory and even common sense support the idea, I'm hoping that this greater understanding of the context behind recent performance gives you a fuller picture of how to think about returns going forward.

9:17As always, you can find all the resources mentioned here in the episode at thelongterminvestor.com. Please go ahead and like, subscribe, leave comments wherever you're listening to podcasts. Thanks as always for listening. And until next time to Long-Term Investing.

9:58and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.