International Stocks: 3 Reasons Why Retirement Investors Should Own Them
20:16 Share

Diversification is a good thing, but with international stocks underperforming U.S. stocks for the last 50 plus years, retirement investors are naturally questioning if it's time to finally give up on this struggling asset class. Was the late John Bogle right when he said that investors don't need to own international stocks?

that, quote, we do better than the rest of the world? Well, technically, he was right. U.S. stocks have done better than the rest of the world since 1970, as far back as the data goes. And not only have U.S. stocks delivered higher returns over the last five decades, but they've done it with less risk and less volatility.

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm sharing why owning international stocks for the last 50 years, despite the disappointing track record, was actually a winning strategy. I'm also sharing why owning international stocks inside of a diversified portfolio for the next 50 years and beyond is likely a wise decision as well, especially for those in retirement.

For the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 188.

From January 1st, 1970 to December 31st, 2022, US stocks, as measured by the S&P 500, had an average annual rate of return of about 10.4%. Developed international stocks during that same time period delivered an average annual return of about 8.2%. 10% versus 8%, both very respectable returns that I think most investors would be happy with.

But those percentages don't tell the whole story. So let's put some dollar figures to this. Let's say that you invested $10,000 in the S&P 500 in 1970. If you reinvested all of your dividends and stayed the course, by the end of 2022, your original investment would have grown to about $1.9 million.

On the other hand, if you invested that $10,000 in developed international stocks instead, you would have only ended up with about $660,000. To make matters worse, international stocks were slightly riskier during that 53-year time period, with an annualized standard deviation that was 1.5 points higher than U.S. stocks. While

While nearly $2 million is a significantly better result than $660,000, I'm going to take it another step forward and argue that those dollar figures don't tell the whole story either. Specifically, I'm going to share three main reasons why owning international stocks inside of a diversified portfolio these last five decades was actually a smart decision for most investors, despite the sizable outperformance of U.S. stocks.

These three reasons, in my opinion, also make a good argument for why owning international stocks for the next 50 years and beyond is likely a smart decision as well.

So reason number one, investment returns are lumpy. Let me explain. Charlie Ellis once said, quote, the average long-term experience in investing is never surprising, but the short-term experience is always surprising. Now, most investors know that U.S. stocks have had an average annual rate of return of about 10% throughout history. The media and financial education platforms have cemented that number in our heads. But

But what most don't know or often forget is that U.S. stocks rarely deliver 10% returns. In fact, since 1927, U.S. stocks have had more years with returns between 15 and 20% than any other range measured. Investment returns are lumpy. Sometimes U.S. stocks go up a lot. Sometimes they go down a lot. And sometimes they don't go anywhere for an extended period of time. The

The same can be said for just about every other asset class, including international stocks. Contrary to what we might have assumed, investments rarely deliver average returns year over year. So why are lumpy returns a problem? And why exactly are lumpy returns a reason for owning international stocks? Well, to start, hopefully most would agree that successful investing is hard.

Our emotions can often get the best of us. It's not easy to invest your hard-earned money only to watch it go down in value in the short term. It's also not always easy to watch your investments go up less than another investment in any given year.

According to the most recent Mind the Gap study by Morningstar, which I'll link to in the show notes, investors on average underperform the asset classes that they invest in by about 2% per year. In other words, if emerging market stocks, let's say, have a positive return this year of 8%, investors on average in emerging market funds will realize a return closer to 6%.

This gap between the average investor's return and the asset class return is commonly referred to as the behavior gap. And that's because it's largely the poor behaviors by investors that lead to this 2% underperformance, buying high, selling low, chasing investment fads, and letting their emotions get the best of them.

One way we can mitigate the behavior gap in our own investing lives is to diversify, to avoid putting all of our eggs in one basket. In fact, Morningstar's annual study continues to show that asset allocation funds have the lowest behavior gap. In addition to the simplicity of these funds, the underlying diversification helps to mitigate those daily ups and downs. It reduces our risk.

As a result of reducing risk, diversification will also likely reduce our rate of return. However, if taking less risk prevents us from letting our emotions get the best of us, we'll likely more than make up for those lower returns in the long run by simply staying committed to our chosen investment portfolio.

As we talked about in the last episode, and I've shared this a number of times in the past, quote, the best investment is the one that you can stick with. It's easy to let our emotions get the best of us and cause us to start thinking that the grass might be greener in another asset class. No single asset class consistently outperforms everything else year over year. Sticking with our investments through all the ups and downs in order to reap those long-term benefits is no simple task.

For example, from 1970 to 1978, U.S. stocks delivered a total return of 50%.

During that same time period, international stocks were up closer to 150%. In other words, international stocks outperformed U.S. stocks by about 100% during those nine years. And keep in mind, that was during a high inflationary time period, a time where every percentage point return on your money was wildly important in order to maintain purchasing power.

But from 1979 to 1984, the trend reversed. International stocks only delivered a 70% total return, while the U.S. market was now up 135%.

From 1985 to 1988, the trend reversed again. U.S. stocks were up 90% during those four years. However, international stocks produced a total return closer to 300%. This was a 200% outperformance by international stocks.

How easy would it have been for an investor to be tempted to bail from their U.S. stock portfolio and chase the performance of international stocks after this time period? And if they did, they would have missed out on 600% total return from U.S. stocks from 1989 to 1999, a time period when international stocks were only up about 130%. This was the largest outperformance by U.S. stocks in history.

This trend continues until present day with each asset class trading periods of under and outperformance. And while U.S. stocks have significantly outperformed international stocks since 1970, they've only produced better annual returns in 28 out of those 53 years. International stocks had better returns 25 of those years, almost a coin toss between the asset classes as to which would do better in any given year.

Again, investment returns are lumpy and unpredictable. Well, it's easy to look back and see that just simply owning U.S. stocks for five decades would have produced the best outcome. It's highly unlikely that most investors would have been able to stay the course during all of those difficult time periods when the positive trend reversed. It would have been an emotional roller coaster.

In addition to the behavioral challenges, lumpy investment returns also create extra challenges for those who are in retirement, taking withdrawals from their nest egg to generate income.

Retirees relying on their investments to fund retirement expenses need to have asset classes that move in different directions. When U.S. stocks had a negative 9% total return from 2000 to 2009, smart, diversified retirement investors could have leaned on their international stocks, which were up almost 20% during that same 10-year time period.

They could have also leveraged other asset classes in their portfolio that performed well, like value stocks, tips, and or AAA rated treasury bonds. To better illustrate how lumpy investment returns can negatively impact those who are in retirement and taking regular withdrawals, let's revisit one of my favorite investing stats that I've shared here before.

So if you retired in the year 2000 with $1 million, invested everything into the Vanguard Total Stock Market Index Fund, withdrew $50,000 per year, adjusted for inflation to pay for living expenses, you would have been out of money by 2018. In 18 years, you would have been out of money.

However, if instead you invested that $1 million in a more diversified portfolio that included global allocations to value companies, small cap companies, and highly profitable companies, and you withdrew that same $50,000 per year adjusted for inflation, you would have ended the year 2018 with a two and a half million dollar portfolio balance. Even if you had invested that $1 million in a more diversified portfolio, you would have

Even great, low-cost, diversified funds like the Vanguard Total Stock Market Fund can introduce these little-known risks. Proper asset allocation and prudent diversification, while not always exciting, is very important, especially for those who are leaning on their retirement nest egg for regular income.

In case you missed it, I published an episode last year on lost decades, which I'll link to in the show notes. If you want to learn more about some of these really unique time periods in history and how smart investors came out the other end relatively unscathed.

So reason number one, investment returns are lumpy and lumpy returns make it challenging for us investors to stay the course and avoid making emotional, oftentimes irrational decisions with our investments. Taking advantage of diversification to reduce the lumpiness of returns, even if it means reducing our future returns, improves the chances that we can stick with our portfolio and reap the long-term benefits.

Diversification also helps those in retirement maintain their retirement paycheck and mitigate the chances of running out of money. Okay, reason number two in support of owning international stocks, not all international investments are equal.

So far, we've been measuring the historical performance of international stocks using the MSCI World X US Index. This is an index that represents the performance of large and mid-cap stocks outside of the US and across 22 developed markets. It's kind of like the overseas version of the S&P 500.

And just like investing in an S&P 500 index fund might be suboptimal, we could make the same argument for investing in an MSCI World Index Fund for our international exposure, or even a Vanguard Total International Stock ETF, which tracks a similar international index known as the FTSE Global All Cap XUS.

These two indexes, S&P 500 and MSCI World, or even the FTSE Global All Cap, these indexes are known as market cap weighted indexes. And I've dedicated two episodes to this kind of confusing topic in the past, which I'll link to in the show notes if you want to revisit them. But put simply, a market cap weighted index fund means that companies with larger market capitalizations get a higher allocation in the fund.

In fact, the top 10 holdings in the Vanguard S&P 500 index fund currently make up close to 30% of the entire fund with names like Apple, Amazon, and Microsoft, i.e. the largest companies. Those are all the top 10 holdings that make up close to 30% of that entire fund.

Just like investing in US stocks, investors have options when investing overseas. They don't have to buy plain vanilla market cap weighted index funds. They can use evidence and academic research to be a little more thoughtful when constructing their asset allocation.

Instead of letting large cap companies dominate their allocation, they can include a healthy allocation to small cap companies. They can also choose to own companies with high profitability and include more value oriented stocks than growth stocks. Historically, by being a little more thoughtful and moving away from market cap weighted index funds, international stock investors, just like US stock investors, have benefited over the long term.

From 1970 to 2022, the same 53-year time period that we've been measuring, small cap international stocks far outpaced the S&P 500. The dimensional small cap international index has averaged about 13.5% per year during that time period. And a $10,000 investment in 1970 would have turned into about $8 million by year-end 2022.

As a reminder, the S&P 500 during that timeframe had an average annual return of about 10.4%. And that same $10,000 investment in 1970 ended 2022 with about $2 million.

We see similar results with international value stocks as measured by the Fama French International Value Index. This data set begins in 1975 instead of 1970. And during this slightly shortened time period, international value stocks had an average annual return of about 12.6% versus 11.8% for the S&P 500 and 8.9% for the MSCI World X US Index. A

Two important things to note here. One, during the time periods measured, international small cap stocks and international value stocks did experience slightly more volatility and risk than your plain vanilla US stocks. So you would have had to accept more risk in order to get that higher rate of return. But I would argue that that is what we should expect as investors over long periods of time. If you want less risk, you should expect lower future returns.

The other thing to note is that we're looking at historical performance of indexes here and not actual investable funds. Properly constructed, low-cost fund options were just about non-existent five plus decades ago, and the solutions that did exist contained high underlying fees, which would have significantly reduced their long-term returns.

The good news is that fast forward to today and investors do have access to index funds that are not market cap weighted and do maintain low fees. You can invest in a low cost international small cap fund or an international value fund and be more thoughtful about your asset allocation in an attempt to improve diversification and potentially also improve long-term risk adjusted returns.

Okay, reason number three, the final reason for owning international stocks, and that is we don't have a crystal ball.

So I've been holding back one important piece of information that I haven't shared with you yet. And that is that the outperformance of U.S. stocks compared to international stocks over the 53 year time period that we've been discussing today is more recent than most investors might realize.

More specifically, from 1970 to 2010, U.S. stocks and international stocks were more or less neck and neck, 9.9% average annual return versus 9.4% respectively. In other words, most of the 53-year outperformance that we discussed at the top of today's show came in just the last decade. Think about that. For the first 40 years, U.S. stocks and international stock returns were nearly identical.

But then you include the last 13 years and the ending result of the entire 53-year time period being measured looks entirely different. Kind of crazy how a slight change in time periods can dramatically alter the results of an analysis.

With that in mind, what might happen over the next 13 years? And how will that change the long-term performance of these two asset classes? Well, if history is any indication of the future, it's likely that international stocks will at some point have their time to shine again. In fact, since October of 2022, when the markets bottomed, developed international stocks are quietly up almost 30%. U.S. stocks, on the other hand, are only up about 18%.

Could the tide be turning for international stocks? Will the outperformance continue for the next three, five, or 10 years? I don't know. Nobody knows. And that's why we diversify. The last thing we want to happen, especially if we're nearing retirement or already retired, is for a large percentage of our portfolio to go through a multi-year period of negative returns.

The lost decade in the early 2000s, contrary to what headlines might've led people to believe was only a lost decade for market cap weighted us stock investors as shared a few minutes ago, globally diversified investors who had a well-constructed portfolio fared quite well during a time period, a 10 year time period where broad base us stocks had a negative total return and dropped by 50%, not just once, but twice.

Diversification has clear benefits, but that doesn't make it easy. As Brian Portnoy famously said, diversification means always having to say you're sorry. A diversified portfolio will always include something that leads to some disappointment or at the very least lead an investor to wonder if it's time to give up on an investment that's underperformed.

I want to be extra clear as we wrap up here, including international stocks in your portfolio will not protect you from catastrophic events. International stocks like U.S. stocks are a risky asset class. If the U.S. goes through a severe recession and U.S. stocks collapse, so too will international stocks. Including international stocks helps protect investors from long-term pain.

like the pain U.S. investors experienced from 1970 to 1978, or from 2000 to 2009. Including international stocks in a properly diversified portfolio helps to manage risk, improve the chances an investor can stick with their portfolio for the long run, and help those who are in retirement generate a more reliable retirement paycheck from their nest egg while mitigating the chances of running out of money.

Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 188. Thank you as always for listening, and I will see you back here next week.