Global Diversification: Free Lunch, Anyone?

“It’s better to be vaguely right than precisely wrong.” — John Maynard Keynes, economist

What percentage of your portfolio is allocated to US stocks? While the US stock market is easily the world’s largest equity market and represents about half of the global market capitalization, there are thousands of investment opportunities across the globe you might be missing out on.

The average American allocates roughly 80% of their portfolio to companies domiciled in the US — a massive overweight known as home bias. Home bias haunts investors all around the world: Australians hold a high percentage of Australian stocks, Canadians hold a high percentage of Canadian stocks, and so on. A portfolio concentrated toward one country is effectively an active bet that it will outperform the rest of the world.

Though US stocks have performed well over the last decade, the United States has never been the single best-performing country for annual stock market returns over the past 20 years. To make matters worse for home-biased investors, there is no discernible pattern for the timing of country performance — returns are random, highlighting the difficulty of executing a strategy predicated on choosing one country over another.

Ideally, one could forecast which countries would outperform, but there’s no evidence anyone can reliably do so. Lacking that foreknowledge, your next-best option is to own all countries as part of a globally-diversified strategy.

The average long-term returns of US and international equities are similar, but their paths deviate greatly. US vs. international performance has been highly cyclical. From 2000–2009, US stocks (S&P 500) were down 9.1% cumulatively — an entire decade of negative returns. The US was one of the best performers in the 1990s, but before that you have to go back to the 1920s.

Finally, valuations today point to a higher probability of international stocks outperforming US stocks over the next decade. International valuations haven’t been this low relative to the US in 20 years. Current valuations don’t tell us much about short-term returns, but they tend to tell us a lot about longer-term returns.

Diversification is often referred to as the only free lunch in investing, because a portfolio of globally-diversified stocks should be expected to produce a superior risk-adjusted return than any one country held in isolation, while also decreasing volatility. Due to the randomness of returns, the cyclical nature of performance, and current valuations, there might never be a better time to diversify your portfolio.