When we start working with them, most of our customers have some portion of their portfolio invested in international stock funds. Many investment professionals encourage investors to own international stock funds to diversify their portfolios. The idea behind this concept is that certain international stock markets may have better growth potential than the US market or may perform better when US markets are down.
But should you invest in international stocks and how much should you invest?
As you know, I am a data geek and a logic nerd. So, of course, I am going to turn to the data to answer this question.
The short answer is no. You should not bother with international stock funds. Let’s look at the data.
If you’ve read my most recent book, Picking the Best Funds for Your 401K, I explain my decision-making process for evaluating funds or any investment. Without a rigid and consistent process to evaluate investments, people are using gut and emotions which rarely work. I am never interested in opinions about investments if they are not backed up by rigorous analysis.
Here are the three main areas that I use to evaluate any investment.
Performance – particularly long-term performance (10 years, 20 years, 30 years).
Consistency and Volatility – Consistency equals predictability.
Conviction – Knowledge and understanding of an investment and why it should perform well keeps you committed to the investment.
Let’s compare the S&P 500 index funds and the Nasdaq (large cap stocks) as investments against international stock funds by running through my three key criteria.
There are a variety of different international stock funds. Some focus only on developed countries. Some focus on emerging markets. Some focus on particular geographic regions like Europe or Asia. Most 401K plans only offer one or two international funds. Today, I am going to use the EFA World Index fund for comparison purposes. This is a global stock fund that includes companies from all the major international markets except the US. Emerging market funds perform worse than global stock funds, so I won’t be covering them today.
Performance
Here are the performance statistics for the funds over the last 30 years.
As you can see, the investment performance isn’t even close.
The US large cap funds are the clear winners for long term performance.
Consistency & Volatility
How did the two funds perform during bear market declines? This tells us about volatility.
There is not much difference in performance between US and international funds in bear markets. The international fund does slightly better in bear markets because it pays a higher dividend (3.2% dividend for EFA vs. 1.3% for the S&P and 0.66% for the Nasdaq).
For the most part, international stocks follow the same bull and bear market cycles as US stocks. So, there is no diversification advantage to owning international stocks.
Conviction
Understanding an investment leads to more conviction in that investment.
Gold is an example of an investment that I would have no conviction over. Yes, gold does tend to outperform stocks in bear markets, but it performs so much worse most of the time that you are only going to lose by owning gold in the long run. If anyone could accurately predict bear markets, then they could get in and out of gold at the appropriate times but nobody can do this.
The key issue here though is conviction. If you follow gold and the supply and demand story of this commodity, you soon realize that nobody understands what makes gold go up in value or down in value except after the fact. I could come up with some great stories about why gold has been on such a strong run recently, but anyone that tells you they saw it coming is not being honest.
When I have no idea why gold goes up or down, I have no conviction. Gold doesn’t produce any earnings that we can analyze. It doesn’t pay a dividend.
Let’s view international funds through that same lense. The US and international funds are both highly diversified with hundreds of individual stocks making up each fund. Like the S&P and the Nasdaq, EFA is heavily weighted toward large cap stocks.
The only difference is geography. Both the S&P 500 and the Nasdaq trade on US stock exchanges. The stocks in the EFA trade on stock exchanges outside the US. Where a stock trades does not tell you where they do business. The US funds contain large companies that generate sales all over the world. Most of the EFA companies are global as well.
So, the difference is mainly where companies are based. Do US based companies have a competitive advantage? I believe the answer is a clear yes.
My international customers might disagree with my answer, but the data is very clear. The US market has produced the best performing and most innovative companies in the world and it continues to do so.
Some of my international friends say that the historical performance does not guarantee future performance. I agree. But where are the signs of global economies producing the best companies in free markets. China can produce excellent companies in a nationalized economy, but China has many risks that the US does not have.
I am also not saying that there are no great companies outside the US. There are just not enough of them to make up a large cap index fund that matches the US large cap funds.
Things can obviously change in the future but based on what we know today - which companies or economies do you see winning over the next 20 years? Do you really think the global stocks are going to start producing double digit annual gains to compete with the US funds when they are only growing at 5% per year now?
One of our subscribers who doesn’t agree with my position argues that the Swiss market beat the US market over a period of several years. I didn’t find any evidence of this, but we could all find a stock or a fund that beats the US large cap funds over small periods of time. But if they fail to outperform in the long run, does it matter? You would have had to know which markets or funds were going to outperform in advance to take advantage of these rare situations. And you would need to know the exact time to get out of that market when it went back to underperforming. I don’t know anyone who has a crystal ball that can predict the winning markets and the exact timing in advance.
Another Risk Factor – Currency Risk
When you own stocks that trade outside the US, you also face currency risk.
Let’s say that a group of global stocks outperformed the US funds by 2% in a particular time period. If the exchange rates became unfavorable, you would come up short when you exchange those stocks for dollars. The opposite is also true where the currency translation might work out in your favor. I find playing the currency markets to be more difficult than investing in stocks. US investors buying US funds do not face any currency risks.
I like to play the long game where the odds are in my favor. As of right now, I don’t see any developments on the horizon that would indicate that international stocks will beat the S&P 500 or the Nasdaq over the long term. In fact, the data suggests that any money invested in international funds will cut my returns in half.
When your financial advisor tells you that you need international exposure, show them this information and ask them what they could possibly be thinking?
Stay Disciplined My Friends,
Phil
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
You may have seen the articles in the financial press about the forecasts for the stock market over the next ten years. Most of the big investment firms are expecting a decade ahead with low or mediocre returns for stocks. Here are some of the forecasts for the returns of the S&P 500 over the next decade.
Projected Annual Return % | |
Next 10 Years | |
Goldman Sachs | 3.0% |
Charles Schwab | 3.4% |
Vanguard | 4.5% |
JP Morgan | 6.7% |
Yardeni Research | 10.6% |
Remember that the S&P 500 typically generates average annual returns of about 10% per year over ten-to-twenty-year time periods.
So why are most people calling for such low returns? With the exception of Yardeni Research, the big firms are expecting stock market returns to be about half of what is considered average or normal.
The reason is something called “Reversion to the Mean”. Because returns have been so far above normal for the last 15 years, it will take many years of low returns to bring the results back to the average.
The average annual returns for the S&P 500 have been right around 14% for the last 10 years and the last 15 years. So, the market has outperformed by about 4% per year over the last 15 years (40% above normal). Since these excess returns were not driven by an increase in corporate profits, most people (including me) feel that the current market is overvalued.
Just doing some simple calculations, to bring stock valuations back into line over the next decade leads you to lower than average returns.
Another point of reference which illustrates Reversion to the Mean in practice is the 30-year time period between 1980 and 2009. The 1980’s and the 1990’s were tremendous decades for the stock market. The average annual return for the 80’s and 90’s was about 14% per year without dividends and about 16% per year including dividends.
After two consecutive decades of outstanding returns (60% above average), we were due for a decade like the one we experienced between 2000 and 2009. In the first decade of this century, the S&P 500 dropped by 2.7% over the 10-year time period. Even after including dividends stocks actually lost money in this period.
Reversion to the mean is a real thing.
My Estimate
Those of you that know me are aware that I don’t like to make short-term predictions for the stock market. This is because getting short term market predictions right is almost impossible. The stock market is irrational in the short term.
The stock market, however, is much more predictable in the long term. I prefer to use 20 years as my long-term horizon since returns for 20-year time periods are much more consistent than 10 year periods. But I decided to take the bait this time.
I, too, believe in the “Reversion to the Mean” principle. And I also estimate that the current market as measured by the S&P 500 is overvalued (17.8% according to my models as of 2/1/25). So, I too am expecting below average returns over the next 10 years.
My estimate for the average annual return for the S&P 500 over the next 10 years is 7.2%. My number is below the norm but not as pessimistic as most of the other forecasters.
Key Considerations
The reason I am using the last 15 years actual performance as a reference and not 20 years is because we just started to emerge from the last ugly bear market in 2009. If we were to use the performance of the last 20 years, we would be including the Great Financial Crisis of 2008.
That is one reason why my projections are probably a little higher than the others. Even though the 15-year time period does not include the awful year of 2008, the stock market was still significantly undervalued in 2010 (the start of the 15-year time period). The returns for the last 15 years, therefore, should have been above average to account for the undervalued starting point.
I also factored in a small increase in corporate profitability due to the impact of AI on corporate efficiency. Higher profits equal higher stock prices.
I also expect one big bear market and one smaller bear market over the next 10 years. The important point here is that whether we see 4% average returns or 7% average returns over the next decade, the annual returns will not be smooth. Like most decades, there will be really good years, bad years and in between years. It is anyone’s guess as to when the good years or the bad years will appear.
The following graph is a wild guess that I made for illustrative purposes only. Just to repeat, I don’t make short term market forecasts. This chart of annual returns corresponds with my estimate of 7.2% average annual returns for the S&P 500 over the next 10 years. I created this to set your expectations of how the 10-year average returns will likely come in. The timing will no doubt be way off, but the distribution of returns will look something like this. There will be great years and bad years and mediocre years.
The thing that could cause stock market returns to be higher than my projection is AI. I am a believer in AI as a profit driver. But because we haven’t seen any significant impacts yet, my expectations are conservative. If AI delivers the way many of us think it can, the average returns for the stock market could be over 10% per year. Time will tell.
Stay Disciplined My Friends,
Phil McAvoy
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
The investment industry throws around all sorts of statistics regarding the risk of particular investments. They even have a measure of investment performance that they call “risk adjusted returns”.
For every investment, the industry calculates:
Beta (a measure of volatility)
The Sharpe Ratio (a way to compare risk adjusted returns)
Standard Deviation (another measure of volatility)
Do you find these statistics helpful? How do you feel about a Sharpe Ratio of 1.5 compared to a Sharpe Ratio of 2.7? They don't help me.
The typical investment advisor also asks clients to fill out a risk profile survey. The objective is to see how much risk a person is willing to take to achieve higher returns. But do people really understand what a higher or lower risk profile score means? Can the advisor somehow magically dial in the perfect investments to match a risk profile score? The answer to both questions is NO.
The reality is that the industry’s preferred risk measurements don’t tell investors what they want to know. So, I created my own.
What investors are concerned about is:
How much money could I lose?
How long will the losses last?
Drawdown
I have always felt that Drawdown is the most important statistic that measures risk for any investment because it measures risk in a way that we all can relate to.
Drawdown is simply the maximum percentage decrease for an investment in a particular time period. Drawdown is most typically utilized during bear markets. It measures the peak to trough decline during a time period.
For example, the Nasdaq Index reached an all-time high of 5,048.62 on 3/10/2000 just before the dot-com crash occurred. Over the next couple years, it dropped to a low of 1,114.11 on 10/9/2002. This percentage decline of 77.9% represented a drawdown of 77.9%.
Time to Recover
Losing a lot of money with a high drawdown is painful but losses are even more painful if they last a long time. If the value of an investment goes down but recovers quickly, we experience less pain.
I measure Time to Recover as the time between the pre-crash peak and the time that an investment gains back all of the losses and returns to the pre-crash peak. I measure time to recovery in years.
In my Nasdaq example from the year 2000 above, the Nasdaq index did not return to the pre-crash peak of 5,048.62 on 3/10/2000 until 07/16/2015. The time to recover in this case was 15.3 years. If you had $100,000 invested in the Nasdaq in early 2000, you would have seen your investment drop all the way to about $22,000 and you would not have recovered those losses for 15 years. Now that is painful.
Older investors need to pay close attention to recovery time.
The Investor Pain Index
I calculate the Investor Pain Index as the product (multiplication) of the two important risk statistics – drawdown and time to recovery.
For example, a drawdown of 30% that includes a 3-year time to recovery produces an Investor Pain Index of 90 (3 times 30).
The higher the score, the more pain that is inflicted upon the investor. So, we are all looking for investments that have high returns and a lower Investor Pain score.
Below is a table comparing the bear market averages for the last 50 years of the S&P 500, the Nasdaq and my Market Signals investment system.
In a typical bear market in stocks, we can expect the S&P 500 to drop around 39% and the Nasdaq to drop around 45%. And it takes around 4 years for both indices to rebound from those losses and get back to even. The investor pain index is 174 for the S&P 500 and 267 for the Nasdaq. This is why people talk about the Nasdaq being more volatile than the S&P 500. It typically posts higher returns than the S&P but it tends to lose more money in downturns.
Compare the two major stock indices to our Market Signals system. This one chart shows you exactly why we created Market Signals. It incurs lower losses in bear markets (14%) and gets back to even much faster (1.6 years). The Investor Pain Index for Market Signals is only 24 or about 90% less than the major stock market indices.
Even better, during bull market expansions, Market Signals posts gains that are similar to the S&P 500 and the Nasdaq. This is how we are able to beat the market. Losing less in bear markets equals higher overall gains. It is simple math.
I encourage you to look at your own investments this way. Look at how much money your investments lost in previous bear markets and how long they took to recover. These are the two most important risk statistics in investing.
Stay Disciplined My Friends,
Phil McAvoy
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
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