The Importance of International Diversification

International diversification

With a seemingly constant drip of bad news from around the globe—military conflicts in Eastern Europe and the Middle East, the spread of Ebola, slowing economic growth in Western Europe and many emerging markets—it may feel that the US is the only safe place to invest your money. But not having enough exposure outside the US means not enough diversification, and that can actually mean higher risk and potentially lower returns over the long run.

The performance of international stocks is driven by some of the same factors that affect US stocks. An upturn or downturn in the global economy, for example, may have an impact on stocks from all countries. But there are plenty of other things that can affect stocks in some countries but not others, such as different valuations, different economic growth rates, different demographics, and different political environments.

These differences mean that international stocks often don’t move in lockstep with US stocks. US stocks substantially outperformed international stocks in 2013, for example, but actually underperformed in 2012 despite the economic woes of the euro zone. Having exposure to both the US and to international markets therefore can mean fewer large ups and downs for your entire portfolio.

Despite overseas wars and economic weakness abroad, the benefits of a globally diversified portfolio may become even more apparent in the coming years. As we’ve noted before, US stocks currently appear to be slightly overvalued by historical standards. This fact doesn’t necessarily mean that US stocks will do poorly, but it increases the chances that their future returns will be below average.

Valuations on international stocks, by contrast, appear to be more in line with historical norms. Strategists at Research Affiliates project that over the next 10 years, current valuations will reduce the returns on US stocks by an average of 1.5% per year. For international developed stocks they think this number will only be 0.6% per year, and for emerging market stocks they think current valuations will actually increase returns by an average of 0.4% per year. Not having enough international exposure, in other words, could mean more risk and less reward.

How Fast Will China Grow?

China GDP

For many years China experienced extremely rapid economic growth, with its GDP often growing by more than 10% in a year. In the last few years its growth has slowed a bit, and the International Monetary Fund (IMF) projects that its growth rate will fall to 7.3% next year and 6.5% by 2019. While this is a substantial decline from some of its sky-high growth rates in previous years, these numbers still represent very rapid growth. By comparison, US economic growth has averaged less than 2.5% per year during the past 5 years.

But can China continue to grow so quickly? New research from two Harvard economists, Lant Pritchett and Larry Summers, suggests that China’s growth rate may fall more than the IMF projects. They find that how much an economy has grown recently doesn’t tend to have much impact on how much it grows in the future. Their calculations show that China’s growth rate is likely to average less than 4% over the next 20 years.

There’s only a weak link between a country’s economic growth rate and how well its stock market performs, so a slowdown in China doesn’t necessarily spell doom for Chinese stocks. It’s very plausible that Chinese stocks could do well even if the country’s economic growth continues to slow as the IMF projects.

But part of the reason the link is so weak is that investors can anticipate when the growth rate is going to increase or decrease and “price in” this change before it actually occurs. It’s unlikely that investors have already priced in a decline in the Chinese growth rate as dramatic as the one Pritchett and Summers project. If their pessimistic forecast comes to pass, the performance of Chinese stocks is likely to suffer.

Reacting to a Stock Market Decline

S&P 500 Index Declines

The last month has been a rough one for the stock market. The S&P 500 index of large US stocks has fallen by more than 7% in the last four weeks (as of the end of the day on October 16th), and many international stock markets have fared even worse. Such a sizable decline can be painful, especially since stocks in general have done so well since the end of the global financial crisis in 2009. But sticking to your long-term strategy, rather than panicking and trying to change things up in response, is (as usual) probably the right way to react.

Put in a broader historical context, it’s clear that the recent market decline isn’t too unusual. In fact it’s rare when there’s a year when the stock market doesn’t fall at least 7% in a four-week period. Such a decline occurred for the S&P 500 index in 2012, multiple times in 2011 (remember the debt ceiling crisis?), multiple times in 2010, and multiple times in 2009.

Panicking during any of these declines may have seemed reasonable at the time, but reducing your exposure to the stock market would have resulted in missing out on some of the gains during the bull market that’s lasted more than 5 years. Even after its recent decline the S&P 500 index is more than 170% above its March 2009 low.

That’s not to say that markets always surge following a moderate decline: in 2007 (shortly before the worst of the financial crisis) and in the late 1990’s (shortly before the bursting of the tech bubble), stocks continued to fall for an extended period of time rather than bouncing back up. But the overall historical record suggests that a moderate drop in the stock market is not a good reason to panic.

How to Use Dollar-Cost Averaging

Money Bags

What should you do when you have a large chunk of money to invest? Deciding whether to invest it immediately or wait for what you think is the right time can be a difficult decision.

Markets go up more often than they go down, so in theory you should invest your money as soon as possible in order to “put it to work” and have the best chance of maximizing your wealth. But markets certainly don’t always go up, so investing a lot of money at once can be nerve-wracking. Markets could fall shortly after you make your investment, and you could easily regret your decision.

A more comforting alternative may be what’s called “dollar-cost averaging,” which means periodically investing a portion of your money over a preset period of time. For example, instead of investing all at once you could invest 25% of the money every 3 months over the course of a year. If markets fell right after you started investing, only 25% of your money would have been affected (and the fall in prices would actually increase the number of shares you can afford to buy with the remaining 75%). Part of the appeal of this procedure is that by having a set plan rather than taking a more ad hoc approach, you can ensure that you’ll be fully invested by the end of the one year period.

Those benefits don’t mean that dollar-cost averaging is always the best tactic. If markets go up rather than down you’ll give up some gains during the time when you’re only partially invested. But giving up some potential gains may be worth the peace of mind that comes with having a well-defined plan that reduces your exposure to the possibility of an imminent market drop.

Understanding the “Momentum Effect”

Momentum

Often it’s safe to assume that what goes up must then come down. With investing, however, it’s not quite so simple. Studies have shown that stocks tend to have a “momentum effect,” meaning that stocks that have recently gone up are more likely to do well in the near future (and that stocks that have recently gone down are more likely to do poorly in the near future).

There are a few possible explanations for this phenomenon. One is that investors struggle to immediately digest new information, so it takes a while for good news or bad news about a company to be fully reflected in its stock price. Another explanation is that people tend to invest in funds that have done well recently, which also happen to be the funds that hold stocks that have done well. When new money flows into these funds, it further pushes up the prices of these stocks.

So should you start buying stocks that have recently gone up? Not so fast. There are high trading costs in any strategy that involves buying and selling a lot of stocks, and the momentum effect only applies in the short term (perhaps 3 to 12 months). Over longer periods of time, stocks that have done poorly in the past actually tend to do better.

Furthermore, there is evidence that while professional investors can effectively use momentum strategies, individual investors often don’t fare so well. Individual investors tend to take the idea too far, focusing only on the top-performing stocks (an “extreme momentum” strategy) rather than stocks that have merely done well.

Q3 Recap: US Dollar Rises as Political Risk Predominates

The third quarter of 2014 was full of geopolitical turmoil: Russia’s proxy war with Ukraine, renewed US military involvement in the Middle East, and Scotland’s independence referendum were among the notable events that took place. In the investment world, this mayhem translated into weak stock markets and a rising US dollar relative to most other currencies.

The rising value of the dollar contributed to a terrible performance for commodities, which had their worst quarter since the global financial crisis in 2008, and losses for both stocks and bonds outside the US. The only asset classes that eked out slightly positive returns in the quarter were US investment grade bonds and cash.

Q32014 Asset Classes

The energy sector was the worst-performing stock sector as falling commodity prices hurt energy companies. The sector’s plunge makes energy one of the worst-performing sectors year-to-date; the health care sector, which continued to post solid returns in the most recent quarter, is now the top-performing sector so far this year.

Q32014 Stock Sectors

Stocks in every developed country outside of the US took a beating. Some of the smaller European countries such as Austria and Greece fared worst, but Australia, Germany, Italy, and Spain were among the other countries that had worse than -8% returns for the quarter.

Q32014 Countries

Political risk will likely continue to play a key role in financial markets going forward: additional political instability could cause the trends from the third quarter to continue. Much will also depend on the actions of the Federal Reserve in the US and the European Central Bank in Europe, which are moving their policies in opposite directions. The Fed is winding down its “quantitative easing” program that was aimed at boosting the economy and is now talking about raising interest rates next year, while the ECB is desperately trying to foster faster economic growth. If the ECB succeeds, European stocks could reverse the shellacking they experienced this past quarter.