Making the case for international equity allocations

A key tenet in investing is that broad diversification can help reduce volatility. Investors may not recognize that investing solely in domestic stocks carries idiosyncratic risk, even if their portfolios are broadly diversified in their home market. In doing so, they forgo exposure to an array of economic and market forces in other countries that tend to produce returns different from those of their home market.

“Country risk is like sector risk,” said Kresnak. “They both tend to lead to greater volatility that could be mitigated through broader diversification.”

Over the past decade, a broadly diversified U.S. stock portfolio would have returned almost twice as much as a comparable international portfolio for a U.S.-based investor.¹ “Disappointing returns may have some investors reconsidering their allocation to non-U.S. stocks,” said Kresnak, “But there’s reason to believe the next decade could look very different.”

The top panel in the figure below breaks down how U.S. stocks managed to produce an average annual return that was 7.5 percentage points more than that of their international peers from April 1, 2013, through March 31, 2023.

Rising stock valuations and higher earnings in the U.S. were the biggest factors behind the differential. Valuations expanded faster in the U.S. because investors expected the American economy and earnings to grow faster than a market-cap weighted average of their international peers and they did. Still, valuation expansion rose more than our fair-value framework would suggest based on interest rates and inflation. Altogether, this contributed 3.3 percentage points of outperformance for U.S. stocks compared with their international counterparts.

Earnings growth added another 3.2 percentage points, a result of stronger margin growth and significantly faster revenue growth than was seen internationally. A U.S. dollar that strengthened over the last decade subtracted 2.1 percentage points from international returns, which more than offset 1.1 percentage points of outperformance due to higher dividend yields.

The bottom panel in the figure below forecasts a turnaround, with an average annual outperformance for international stocks of 2.2 percentage points from March 2023 through March 2033—an outcome based on our median projections of U.S. stocks returning 5.1% and international stocks 7.3%.

We expect to see stock valuations return closer to our estimates of fair-value across the globe—particularly in the U.S., where more pronounced valuation expansion has pushed them to loftier levels. A contraction in valuations of 1.2 percentage points abroad and 1.6 percentage points in the U.S. would result in a performance advantage for international stocks of 0.4 percentage points on average per year over the next decade.

By our estimates, the U.S. dollar is valued about 12% above what long-term fundamental drivers would suggest. The run-up to a strong dollar has hurt international equity performance for a U.S.-based investor in the past, but during the decade ahead, a weakening dollar could add about 1.1 percentage points to international stock returns compared to their U.S. counterparts.

Some trends, however, aren’t expected to change. Dividends of international stocks should remain higher than those in the U.S., adding about 1.4 percentage points of outperformance. And earnings growth will likely remain a tailwind for U.S. stocks in the coming decade, resulting in a modest return contribution of about 0.7 percentage points over international stocks.

From a structural perspective, having an allocation to international stocks makes sense because broad geographical diversification can help reduce volatility in a portfolio. Using a market-capitalization-weighted approach, such an allocation would be roughly 60% domestic stocks and 40% international stocks. A mix in that range could make sense in the equity portion of broadly diversified multi-asset investment products used by self-directed investors.

But there are practical considerations—implementation costs, tax repercussions, regulations, and investment costs—that could lead an investor to consider a different international allocation. And in an advice setting, more personalized costs and tax considerations may be considered to help refine the allocation mix.

From a cyclical perspective, investors with the requisite time horizon, risk tolerance, and interest in an active investment management strategy may consider a modest overweight to international stocks given the prospect that they may outperform over the next decade.

Our base case is supported by the figure below, which shows a preponderance of market return simulations in which international stocks return more than domestic stocks over the next decade. Our simulations suggest that a 60% stock/40% bond portfolio with a market-cap weighted allocation to international assets is expected to return 0.6 percentage points more per year on average and 0.4 percentage points less expected volatility than a domestic-only portfolio.

The figure also shows that there’s a reasonable probability that U.S. stocks could continue to outperform. According to our simulations, however, the likelihood of U.S. stocks outperforming in the coming decade by as much as they did over the last decade is less than 1%. 

“As we’ve noted many times before, forecasting is a humbling exercise,” said Kresnak. “That said, we believe U.S. investors would benefit from lower volatility through an allocation to international stocks. And over the coming decade, it will likely help them achieve higher returns than a domestic-only portfolio—but with moderation being warranted, as international outperformance is far from guaranteed.”

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• Bloomberg Intelligence podcast: Investing over speculating (article, issued April 2023)
• Actively passive with fixed income funds (article, issued March 2023)
• Don’t be too shortsighted in fixed income (article, issued March 2023)