Do You Need International Stocks? The Case for Global Diversification

Key takeaways

The U.S. is about 60% of world stock market value; a portfolio with none of the other 40% is a bet on one country, however good that country has been.
Leadership rotates in long cycles: international beat the U.S. through the 2000s, the U.S. has led since; neither run was predictable at its start.
Valuations abroad have been substantially lower than U.S. valuations for years, which is the strongest argument the expected return gap favors diversifying.
We hold about 30% of equity outside the U.S., built on a broad market core with added smaller and lower-priced companies, and rebalance into whichever region has lagged.

For most of the past fifteen years, an investor who held only U.S. stocks did better than one who held a global portfolio, and the gap was wide enough that the global investor felt a little foolish. That feeling is why we're writing this. Whether to own international stocks isn't answered by which region won recently. It's answered by what diversification does across the periods you can't see coming, and by what today's prices in the two regions imply about the future.

What the world looks like

U.S. companies make up roughly 60% of the value of the world's stock markets. The other 40% is Europe, Japan, the United Kingdom, Canada, Australia, and the emerging markets led by China, India, Taiwan, and Korea. A portfolio that owns only the U.S. has left out Nestlé, Toyota, ASML, Samsung, Novo Nordisk, and TSMC, and has bet everything on one country's economy, currency, tax policy, and stock market valuation.

That concentration has worked. It also worked for Japanese investors in 1989, when Japan was 45% of world market value and had outperformed for two decades. Then came a thirty-year drought. No country's leadership is permanent, and the country that's led longest is always the one where investors are most sure it'll continue.

The cycles

From 2000 through 2009, international developed stocks beat U.S. stocks by a wide margin, and emerging markets by a much wider one. The U.S. had its "lost decade." From 2010 through the mid-2020s, the U.S. led, driven by technology companies and an expanding valuation gap. Before that, the 1980s belonged to international markets and the 1990s to the U.S. The cycles have run five to fifteen years and have reversed without warning. An investor who dumped international stocks in 2009, after a decade of U.S. underperformance, would have had it exactly backward. Today's temptation is the mirror image.

What diversification does

International stocks don't guarantee higher returns. Nothing does. What they do is make the portfolio less dependent on a single market. Correlations between U.S. and international stocks have risen with globalization and run high in crashes, when everything falls together. But over longer periods they stay meaningfully below one, and that's where the benefit shows up: the years when the U.S. is flat or down while other markets rise. The diversification benefit is the smoothing over a full cycle, not protection in a single bad month.

Currency is part of it too. International stock returns to a U.S. investor include the change in the dollar. A weakening dollar adds to foreign returns; a strengthening dollar, which has been the pattern for over a decade, subtracts. For a household that spends in dollars, some foreign currency exposure is a hedge against the dollar's own decline. Over a long retirement, that's a real risk.

Valuation

The most persuasive argument for international stocks today is price. For most of the past decade, U.S. stocks have traded at price-to-earnings ratios well above their own history and well above international markets, which have traded near or below theirs. Some of that gap is justified by the U.S. market's higher profitability and its concentration in fast-growing technology companies. Some of it isn't, and that's the part that matters for expected returns. Lower prices for the same earnings imply higher expected returns, and most long-run forecasts from major asset managers have, for years, projected higher expected returns for international than for U.S. stocks on that basis. Forecasts aren't promises. But an investor who chooses to hold only the more expensive market is making a specific bet that the valuation gap will persist or widen.

How much

Market weight would put about 40% of the equity allocation outside the U.S. Most evidence-based portfolios hold somewhat less, 25% to 35%, reflecting home-bias arguments that have some merit: U.S. investors spend in dollars, the U.S. market is more liquid and better regulated, and the largest U.S. companies already earn a big share of their revenue abroad. We hold about 30% of equity in international markets, split between developed and emerging. Each starts from a broad market core. In developed markets we add small and value companies, and in emerging markets value companies, where the international premiums have historically been at least as large as in the U.S.

The exact number matters less than holding it steadily. An allocation that drifts down to 15% after a decade of U.S. leadership, and then gets abandoned, has captured the worst of both: the underperformance and none of the recovery. Rebalancing into the region that's lagged is what makes the allocation pay.

Cost and tax

International index funds cost a bit more than U.S. ones, 0.05% to 0.15% for broad developed and emerging funds. In taxable accounts, foreign dividend withholding is partly recoverable through the foreign tax credit, which favors holding international funds in taxable rather than retirement accounts. Our asset location post covers that. Emerging market funds are less tax-efficient and belong in retirement accounts when possible.

What we say to clients who ask

That the question comes up loudest at exactly the moment when the answer is least in doubt. That a global portfolio is the default, and a U.S.-only portfolio is the active bet. That the evidence-based approach doesn't know which region will win the next decade and isn't designed to. And that the investment policy sets the allocation so we don't have to relitigate the question every time one region has a good run.

Frequently asked questions

Do U.S. multinationals already give me international exposure?

Partly. Large U.S. companies earn about 40% of revenue abroad. But their stocks trade with the U.S. market, at U.S. valuations, in dollars. That isn't the same as owning foreign companies at foreign prices.

Should I hold emerging markets separately?

A total international fund includes them at market weight, about a quarter of the international allocation. A separate allocation lets you control the size and park it in a retirement account for tax reasons. Either is fine. The important thing is to have some.

What about currency hedging?

Hedged international funds strip out the currency effect and cost more. For a long-term investor the unhedged exposure is a diversifier, and the research finds little benefit to hedging equity over long horizons. For bonds, hedging makes more sense.

Is now a bad time to add international?

The regions that have underperformed are the ones trading at lower prices. Adding after a stretch of underperformance is buying lower. It has never felt good, and it has usually worked.

Joseph G. Valerio, CFP®, EAFounder and Lead Advisor at Valerio Wealth Management, a fee-only, fiduciary virtual family office in Miami, Florida. One advisor, credentialed in both financial planning and federal tax. About Joseph

This article is general education, not individualized advice, and it is not tax, legal, or accounting advice. Figures reflect federal law for the year stated and can change. Valerio Wealth Management does not prepare or file tax returns. Speak with a qualified professional about your own situation before acting.