Market Direction and Stock Trends

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International investing has plenty of benefits — here’s why you shouldn’t oversell them
By: Mark Hulbert | October 16, 2017

The benefits of international diversification largely disappear when they’re needed most

CHAPEL HILL, N.C. (MarketWatch) — International diversification can help an investor’s portfolio. How much, however is something financial advisers need to be careful to avoid overselling, and be realistic about what that diversification can and cannot achieve.

That’s because foreign equities tend to become highly correlated with the U.S. stock market during major bear markets — meaning that the benefits of international diversification largely disappear when they’re needed most.

This doesn’t mean we shouldn’t invest in non-U. S stocks. (Diversification, after all, isn’t the only reason to do so.) But advisers who tell clients that international diversification will greatly reduce the risks otherwise associated with investing in equities are giving those clients false comfort.

This matters especially today, when many believe we’re in the later stages of a bull market.

To appreciate how financial advisers came to exaggerate the benefits of international diversification, it’s helpful to remember that its promise lies in a low correlation between domestic and international equities.

If one category is zigging while the other is zagging, a portfolio holding both should experience less volatility or risk than one that holds just one or the other. Since international stocks have just as good a long-term expected return as U.S. equities, diversification thus holds out the prospect of significantly reducing risk while forfeiting no return. That’s a winning combination.

The problem with this reasoning is that international equities’ much-vaunted low correlation with domestic stocks can be traced primarily to bull markets in U.S. stocks. That low correlation largely vanishes when U.S. equities are in a bear market, when the diversification would be most beneficial.



In other words, domestic and international stocks tend to march to the beats of different drummers when the U.S. market is rising. But during bear markets they tend to fall in unison.

During the Financial Crisis, for example, the S&P 500 SPX, +0.09% EFA, +0.01% fell by 56.8% and MSCI’s EAFE Index fell by 61.0%.

These heightened correlations during bear markets are not a secret. At least in academic circles, this tendency has been widely known for decades. Unfortunately, that knowledge has yet to completely make its way into financial adviser circles.

There may be other reasons besides diversification to invest in international stocks, of course. Better valuations is one: Boston-based money manager GMO, for example, believes that emerging market value stocks are the only category of equities whose expected inflation-adjusted return over the next seven years is positive. (They forecast that the U.S. stock market’s real return over this period will be negative.)

If you believe GMO, therefore, you’d allocate a good portion of your equity portfolio — if not the bulk of it — to non-U. S. stocks.

But that argument is far different than one based on risk reduction.

Kirt Butler, a finance professor at Michigan State University and the author of one of the most widely used college-level textbooks on multinational investing, said in an interview that we must stop claiming international diversification provides something that it really doesn’t.

“Advisers shouldn’t hold out the false hope of great risk reduction through international diversification,” he said.

Instead, Butler said, advisers should focus on the risks of holding equities in general, regardless of whether they are domestic or international. If those risks are intolerable, then their clients should reduce their total equity allocation to a more suitable level.

With the stock market at an all-time high, now would be a very good time for advisers to have just such a conversation with their clients.

http://www.marketwatch.com/story/international-investing-has-plenty-of-benefits-heres-why-you-shouldnt-oversell-them-2017-10-16

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