The writer is a financial journalist and author of ‘More: The 10,000-Year Rise of the World Economy’
It has been described as the easiest free lunch in investment: diversify your portfolio and you achieve a better trade-off between risk and reward. That still seems true when it comes to the number of stocks that investors own within their domestic market.
But new research by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School shows it has not always been the case with international diversification.
Writing in Credit Suisse’s Global Investment Returns Yearbook, the academics examine the history of international diversification since 1974, when Bruno Solnik wrote an influential paper on the subject in the Financial Analysts Journal. In particular, they focus on the experience of US investors.
Many American institutions increased their overseas asset allocation significantly in recent decades; the proportion of non-domestic equities held by US pension funds rose from 1 per cent in 1980 to 18 per cent in 2019.
This diversification did not pay off in terms of total return; US equities beat non-US stocks by 1.9 per cent a year between 1974 and the end of 2021. The outperformance was even greater after 1990, at 4.6 per cent a year.
Nor did diversification help in terms of reducing volatility; on average non-US markets were about twice as volatile as the American market. So the Sharpe ratio, which measures the relationship between return and volatility, was significantly better for American investors who stuck to the domestic market than for those who ventured overseas.
America’s strong performance means that international diversification paid off rather better for investors elsewhere. Out of 32 countries where the academics have detailed returns between 1974 and 2021, international diversification paid off (in risk-adjusted terms) in 24 of them. That figure would have risen to 28 if investors had hedged their currency exposure.
But the big question is whether the future will resemble the past. The US stock market was in the doldrums in 1974, but despite some occasional shocks in the last 50 years, has been remarkably successful. It now comprises 60 per cent of the global market (as measured by the academics) and is even more dominant than the 54 per cent it held in 1974. That is a lot bigger than America’s share of the global economy which is around 24 per cent and down from 36 per cent in 1970.
However, the link between a country’s economy and its stock market is much less clear than it used to be. Many of America’s biggest companies, such as Alphabet, Apple and Microsoft, are global brands that derive a significant proportion of their revenues and profits from outside the US. In a sense, the corporate sector has diversified on investors’ behalf. An investment in the American stock market is no longer simply a bet on the US consumer or on the direction of US monetary policy.
Another factor that may deter American investors from diversifying is that global stock markets are much more correlated than they were before the collapse of the Bretton Woods fixed exchange-rate system in the early 1970s. Between 1946 and 1971, the LBS academics found that the average correlation between the US, UK, French and German markets was 0.11 — a modestly positive link. Between 2001 and 2021, that correlation rose to 0.88, meaning that markets moved in the same direction almost all the time.
Still, geographical risk has not disappeared entirely as the collapse of the Russian market after the invasion of Ukraine has shown. This is not the first time that investors in Russia have seen their portfolios devastated. Russia was the fifth largest global stock market, by value, in 1900, but all value was wiped out after the 1917 revolution.
In 1998, when the Russian government defaulted on its debt, equity investors lost 75 per cent in real terms. Germany was the third largest stock market, by value, in 1900, but investors then suffered three periods of enormous real losses, during the two world wars and the hyperinflationary period of 1922-23.
While nothing that severe seems likely to happen in the US, a bet on its domestic stock market still implicitly assumes that the country’s strong position will continue. The country’s technology giants, for example, have come under attack for their monopolistic positions and their impact on social interactions and could be subject to much more regulation in future.
That could dent their future profits growth or, at the very least, their valuations. The wave of international sanctions on Russia, and the trade tensions between the US and China, suggest that globalisation may be in retreat, and globalisation was generally very good news for the American corporate sector.
It is a reasonable bet that American investors will gain more from international diversification over the next five decades than they did over the last five. Given the greater correlation between global markets, international diversification may no longer be a free lunch but it still seems like a sensible piece of insurance.