The tumultuous world is a scary place for investors nowadays. Yet many advisers still tell American investors to keep their portfolios diversified by holding foreign stocks. The idea is that holding a mixture of US and foreign stocks will reduce volatility and maybe even increase returns.
But is that really true? Is it good advice?
Kenneth G. Winans says that for Americans to think they have to hold foreign stocks is a big mistake. In fact, the veteran investment manager tells his clients that they don’t need to look outside the US at all. He says that’s especially true right now, when Europe is in an economic rut…China is battling a sharp slowdown in growth…Japan has been unable to kick-start its stagnant economy…and low oil prices have pummeled countries ranging from Venezuela and Canada to Saudi Arabia and Russia. And Winans believes the all-American approach makes sense for the long term, too.
We asked him why he holds that belief and why investors should consider adopting this approach…
Foreign stocks have long been subpar performers and a poor hedge against swings in the US stock market. And over the past 10 years, Winans Investments Total Return, my all-US-stock model portfolio, has returned an annualized 9.3% versus 4.3% for the MSCI All Country World Index (ACWI), a benchmark that consists of roughly half US stocks and half foreign stocks. The Winans portfolio also has been about 10% less volatile over that period.
Before starting my investment firm in 1992, when I worked at Merrill Lynch, brokers like me were instructed to make sure that every client had some exposure to stocks of fast-growing foreign countries, especially China. The theory was that those stocks would outperform US stocks. We were told that although foreign stock markets could be volatile, they didn’t necessarily move in unison with US markets, which meant that overall volatility could be reduced by having a globally diversified portfolio.
But this rationale for selling customers on foreign stocks didn’t make sense to me for several reasons. Among those reasons, buying foreign stocks exposes investors to risks that they don’t face with US stocks. Those risks may include corporate accounting practices that fall below the standards required to trade on US exchanges. For example, some countries, such as China and Russia, don’t require companies that are based there to report their earnings quarterly.
Another risk involves foreign currencies. When those currencies weaken in relation to the US dollar, stock prices of foreign companies are hurt when translated to US dollars. Although a weakening US dollar can have the opposite effect, currency trends are very difficult to predict, and they tend to add to volatility.
The biggest problem with global investing is that the potential for better performance and lower volatility just hasn’t panned out. For example, the Standard & Poor’s 500 stock index has outperformed the MSCI index over the past five-, 10-, 15-, 20- and 25-year periods. Meanwhile, over the past decade, the MSCI index has been 10% more volatile than the S&P.
During US bear markets—when global diversification should have been the most helpful—foreign stocks tended to decline in lockstep with US stocks and provide little buffer. For instance, in 2008, when the S&P 500 sank 37%, the MSCI index lost 42%.
You might ask whether an all-US strategy will continue to make sense. After all, US stock markets reached record highs this year, making depressed foreign stocks look like relative bargains. But I’m not convinced that foreign stocks will experience a large rebound or outperform US stocks for the foreseeable future.
My reasoning: The S&P 500, with an average price-to-earnings ratio of 19.5, isn’t particularly overvalued right now despite weakening corporate earnings. And although the US economy is expected to grow by just 2% this year, we’re in much better shape than most of the world.
Despite Japan’s dramatic efforts to stimulate its economy, it is expected to grow a meager 0.9% this year. European Union countries are expected to grow just 1.5% for 2016. And the public discontent that led to the UK’s vote to exit the EU could easily gain traction in other parts of Europe, resulting in more uncertainties. China’s current pace of economic growth is its slowest in a quarter century, and it could persist for years because of the overhang of its real estate bubble and its massive manufacturing overcapacity.
If foreign economies do manage to perk up, a US-only stock portfolio still can benefit. That’s because S&P 500 companies now derive about half of their revenues from foreign markets. So US investors can get indirect exposure to those markets while avoiding some of the risks and volatility that are associated with foreign stocks.
If you choose to adopt my strategy, consider selling all your foreign stocks quickly unless that would result in a big tax bite on capital gains, in which case you can stretch out the sales over a longer period.
New allocations within your stock portfolio…
Invest 60% to 80% of the portfolio in a fund that tracks the S&P 500. Recommended: SPDR S&P 500 ETF (SPY), a low-cost exchange-traded fund.
Invest 10% to 20% in a fund that tracks US mid-cap stocks and 10% to 20% in a small-cap index fund, depending on your risk tolerance and time frame. These asset classes experience much higher volatility than the S&P 500, but they deliver better long-term performance than foreign stocks for the amount of risk you are taking. Recommended: SPDR S&P MidCap 400 ETF (MDY) and iShares Core S&P Small-Cap ETF (IJR).
Use bonds rather than foreign stocks to reduce your overall portfolio volatility if that is one of your goals. Although you can buy individual bonds—which I do with many client portfolios—you instead could choose to invest in a total bond fund, which has a mix of government bonds and corporate bonds of various maturities, such as the iShares Core US Aggregate Bond ETF (AGG). The percentage of your overall portfolio that you should invest in bonds will vary depending on your age, risk tolerance and other factors.
