International stocks help diversify your portfolio
How to invest

International stocks help diversify your portfolio

International stocks help diversify your portfolio
7 minute read
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July 01, 2020
How to invest
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Diversifying

Commentary by Carolyn Cross, senior manager, Vanguard Advice Methodology

International stocks play a key role in your long-term investment strategy. We asked one of our portfolio construction experts, Carolyn Cross, senior manager in Vanguard Advice Methodology, to answer some questions about how non-U.S. stocks help diversify your portfolio.

Why does Vanguard Personal Advisor Services® include international investments in managed portfolios?

Carolyn: One of Vanguard’s principles for investing success is balance—diversification is a powerful strategy for managing risk because it reduces exposure to the risks associated with a particular company, sector, or segment.  

U.S. stocks have outperformed, so why not concentrate portfolios in these stocks going forward?

Carolyn: The benefit of holding U.S. and international stocks is they periodically alternate positions as outperformers. Rather than take the risk of attempting to time the markets by jumping into all U.S. or all international stocks, it’s more effective to have continuous global diversification so you have consistent exposure to the current outperformer. It’s true that U.S. stocks have performed better over the last 10 years, but in the previous decade, international stocks did better [Figure 1].
 

Figure 1: Annualized returns for international and U.S.-based markets - 2000 to 2019

Source: FactSet monthly gross returns, 01/2000 to 12/2019. Developed markets represented by MSCI EAFE Index, emerging markets represented by MSCI Emerging Markets Index, U.S. markets represented by MSCI USA Index.

When performance leadership will change is uncertain. However, we believe that the starting point or valuations matter. Non-U.S. equity valuations are more attractive relative to U.S. equity valuations according to our forward-looking outlook.

What other factors make international exposure important?

Carolyn: Not all great stocks are found in the domestic markets, as companies based outside the U.S. make up nearly half of the value of stocks worldwide. We believe breadth of market exposure is important.

From an industry standpoint, the U.S. looks different from the international marketplace. While our domestic stock markets are predominately technology and health care, the international composition tends to lean heavier toward financials and consumer goods.

When you look at a breakdown of sectors, many industries heavily weighted in the U.S. were among those that outperformed over the past decade. However, as I mentioned previously, performance leadership for sectors, regions, and segments has tended to change over time.

What is it that makes some investors nervous about international stocks?

Carolyn: In our research on global equity investing, we found that investors around the world tend to be more comfortable holding stocks in domestic companies, which are more familiar to them than foreign companies.*

However, if investors take a closer look, they’ll probably recognize many of the companies in their international funds. Vanguard Total International Stock Index Fund, for example, includes Nestle, Samsung, Toyota, and AstraZeneca among its 10 largest holdings (as of May 31, 2020). This fund’s portfolio equity exposure is in both developed and emerging international economies.

What would you say to clients who think international stocks are too risky?

Carolyn: First, your advisor is here for you if you have concerns. They’ll seek to understand what’s on your mind and discuss how best to address your concerns, while ensuring a balanced approach to guide you toward your goals.  

Balance is important, though. Historically, having a mix of international and U.S. stocks has actually tamped down volatility in portfolios [Figure 2].
 

Figure 2: Average annualized change in portfolio volatility when including non-U.S. stocks in a U.S. portfolio - 1970 to 2020

Notes: Non-U.S. equities represented by MSCI World Index ex USA and U.S. stocks are represented by the MSCI USA Index from March 31, 1970, through March 31, 2020. Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index

Sources: Derived from data provided by Vanguard and MSCI as of March 31, 2020

You’ve worked with your advisor to come up with an investment strategy that considered not only your goals but also your tolerance for risk. Your financial plan includes an asset allocation that took all this into consideration, simulating your progress toward your goals under a wide variety of market scenarios.

As we know, 2020 has been full of challenges as the global pandemic has shaken the markets. Equities fell sharply in March, but you stuck with your financial plan as the markets recovered. What’s important to remember during these events—and year after year—is that we’ve positioned your portfolio to handle these ups and downs, and international investments play an important role in that effort.

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*Source: Vanguard, February 2019.

All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

Advice services are provided by Vanguard Advisers, Inc., a registered investment advisor, or by Vanguard National Trust Company, a federally chartered, limited-purpose trust company.

The projections and other information generated by the Vanguard Capital Markets Model® (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the VCMM is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.