Why investing internationally may be good for your portfolio

Remember that saying: don’t put all your eggs in one basket? That’s the same wisdom that applies to investing. And just like the guidance is not to go all in on one company/stock or one industry, the same usually applies for going all in on one country.

Today, we’ll dive into the world of international markets so you can understand why a blend of domestic and international investments often creates a balanced portfolio.

Key points of the post

• International stocks have often outperformed U.S. stocks throughout history. However, in the past 13+ years, U.S. stocks have surpassed international stocks in performance.

• While owning U.S. multinational companies can offer some international exposure, it may not be the optimal method.

• International stocks can be categorized into developed markets and emerging markets.

• Emerging markets typically exhibit lower valuations but carry higher risk.

• According to Modern Portfolio Theory, investors should aim for international exposure proportionate to its market capitalization in the world.

• Plenty provides a platform for members to invest in international stocks.

Long-Term Opportunities In International Equities

The U.S. stock market has grown faster than international markets over the last decade, but historical trends reveal that it doesn't consistently outperform global counterparts. For long term investments, diversifying globally can reduce risk and potentially increase  returns.

As of 2021, the graph provided by Morningstar illustrates that since 1988, the U.S. has only been the top performer (stock market returns) four times. To put it in perspective, this is equivalent to Switzerland and fewer times than Austria. 

Examining the period from January 1, 1970, to July 21, 2022, countries such as Hong Kong, Denmark, Sweden, the Netherlands, and Switzerland have all exhibited a higher average return than the U.S. equity market.

Below is another chart that shows the values of the S&P 500 Index’s returns minus the MSCI World ex USA Index’s returns through 2023. When the line is above 0, domestic stocks outperformed international stocks. 

When the line is below 0, international stocks outperformed domestic stocks.  You can see how the S&P 500 underperformed international stocks during the 1970s, the late 1980s, and from 2003 to 2011 based on the 5-year monthly rolling returns.

U.S. Multinationals Offer Some International Exposure

An alternative approach to international investing involves investing in prominent U.S. multinational corporations like Chevron, Pfizer, and Apple. U.S. multinationals are characterized by U.S.-based companies generating a minimum of 25% of their revenue outside the U.S. 

Consequently, these companies benefit from heightened overseas demand for their products. For instance, if iPhone sales are thriving in China, Apple stands to gain.

However, U.S. multinational companies tend to specialize in specific sectors of the global industry like technology or healthcare companies. If your goal is to include international companies from diverse industriesU.S. multinationals may be less helpful.

The majority of U.S. multinationals fall into the Large Cap category ( companies with a market valuation of $10 billion or more). Operating overseas factories and managing international distribution channels often requires substantial resources.

For investors looking for international diversification, directly investing in international companies may be the most straightforward way to gain foreign exposure. 

Main Risks Associated With Investing Internationally

Investing in international stocks can offer diversification benefits, especially if you have an over concentration of stocks in your home country. but it also comes with its own set of risks. As you will notice when you increase the risk dial when describing your risk tolerance on Plenty, the international exposure increases.

Here are some main risks associated with investing in international stocks.

Currency Risk

If the local currency weakens against your home currency, the returns may be reduced when converted back. For example, if the U.S. Dollar appreciates against the Chinese Yuan, sales of the iPhone in China will translate back into lower U.S. Dollar revenue because it takes more Yuan to buy one US dollar. 

Below is a chart that illustrates how the S&P 500 Foreign Revenue Exposure Index (gold line) declined more than the S&P 500 Index (purple line). For context, 2022 had a -19.6% decline after the Fed started aggressively raising the Fed Funds rate. As U.S. interest rates rise, the USD tends to strengthen given higher interest rates attract more capital buying U.S. assets. 

Political, Geopolitical, and Regulatory Risks

The United States is considered a relative safe haven given our political and regulatory stability. Other countries can experience greater political and geopolitical instability.

When Russia's Putin decided to invade Ukraine, the Russian stock market collapsed by 39% in a day. The Russian ruble fell to record lows, as Russians rushed to convert rubles into other currencies (like USD). 

Economic Risks

Economic conditions vary across countries, and factors like inflation, interest rates, and economic growth can impact the performance of international stocks. For example, governmental policies have led to hyperinflation in Argentina, and money individuals have saved are rapidly decreasing in value.

Market Liquidity

Some international markets may have lower liquidity compared to major domestic markets, making it challenging to buy or sell assets without affecting prices.

The New York Stock Exchange, for example, is about 25 times bigger than the Brazilian stock exchange in terms of volume. 

Corporate Government, Accounting and Reporting Standards

Different countries often adhere to distinct accounting standards and reporting practices, posing a challenge for investors attempting to accurately evaluate the financial health and performance of international companies.

Corporate governance standards may not align with the expectations of U.S. investors when investing internationally. This encompasses factors such as shareholder rights, transparency, accountability, board effectiveness, risk management, engagement with shareholders, and compliance.

A recent example of corporate governance risk is the downfall of FTX, a cryptocurrency exchange overseen by Sam Bankman-Fried. The revelation that FTX utilized customer deposits to invest in speculative assets led to a mass withdrawal of deposits.

Global And U.S. Market Drawdowns

In terms of historical downside risk, investing internationally may also pose greater downside risk than investing in U.S. markets. During a global bear market, there tends to be a flight to developed countries with more financial stability. 

The Right Mix Between International And Domestic Exposure 

Every investor has unique risk tolerance and goals. That's why Plenty offers investors the flexibility to adjust their risk tolerance, and therefore international exposure, according to their individual preferences.

Modern Portfolio Theory (MPT) suggests a strategy of investing in the global market, with each asset class weighted based on its market capitalization. Given that the U.S. market constitutes approximately 60% of the global market, for the equity portion of an investor’s portfolio, MPT recommends a U.S. investor allocate around 60% to U.S. stocks and the remaining 39% portion to non-U.S. stocks.

As illustrated in Figure 3 below, the introduction of non-U.S. stocks to the portfolio in incremental amounts results in a decrease in volatility. Historical data indicates that portfolio risk is minimized when non-U.S. equity comprises between 35% and 40% of the total equity exposure, representing a potential optimal diversification point.

Often Cheaper Valuations With International Stocks 

Another reason to own international stocks over the long term is that valuations are often more attractive overseas. If non-U.S. stocks are priced at a discount relative to their U.S. counterparts, then such stocks may be viewed as more attractive. Cheaper valuations now for these stocks suggest that they have the potential to deliver above-average returns in the long term. 

According to Scott Abernethy, CFA, Regional Director, Private Asset Management at TIAA, "An allocation in the 35% - 40% range provides the potential for increased diversification and improved risk-adjusted return.” 

Developed International vs. Emerging Markets

Investing internationally is generally differentiated between Developed Markets and Emerging Markets. 

Developed markets have more advanced economies, better-developed infrastructure, more mature capital markets, and higher standards of living. Most developed markets are located in North America, Western Europe and Australasia. They include countries like the United States, Canada, Germany, the United Kingdom, Australia, New Zealand and Japan. 

Emerging markets, on the other hand, are in the process of rapid growth and development but they have lower household incomes and capital markets that are less mature than developed countries. They are characterized by fast economic growth with weaker infrastructure and lower household incomes. 

MSCI defines Emerging Markets based on the assessment of three dimensions: 1) economic development, 2) size and liquidity of equity markets, 3) market accessibility for foreign investors.

Currently, emerging markets include the so-called “BRIC” countries (Brazil, Russia, India and China), as well as Portugal, Ireland, Italy, Greece and Spain. For investors with greater risk appetite, investing in Emerging Markets may be more attractive. 

MSCI Emerging Markets index composition

Why Invest In Riskier Emerging Markets

Historically, Emerging Markets have shown higher average returns ( along with higher volatility), compared to developed markets. Individual emerging markets tend to have low correlation between countries, reducing the risk associated of investing in the entire group as opposed to individual countries.

As you can see from the chart below, Emerging Markets (blue line) have underperformed Developed Markets since January 2014. However, prior to 2014, Emerging Markets outperformed. Increasing access to the internet, higher education levels, and a comparatively younger workforce will contribute to driving future growth. 

Conclusion To Investing Internationally

The essence of long-term success in investing lies in the art of diversification. A skillfully managed portfolio not only weathers market shocks but strategically positions itself for sustained growth. While investing inherently involves uncertainties, venturing into international markets adds a layer of potential growth to your portfolio over the course of time.

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