Should you own international stocks?

Whereas U.S. stocks and bonds are the foundations for investing for U.S. based investors, many portfolios also hold global equities which make up over half of the world stock market. Let’s break down what role international stocks can play.

What do the experts say about international investing?

John Bogle, the patron saint of the individual investor for spearheading the first index fund through Vanguard, repeatedly states in his book, Common Sense on Mutual Funds[1], that he wouldn’t suggest investing more than 20% of his equity portfolio in international funds:

If our diamond lode is within our own borders, shouldn’t the investments we choose for our portfolios stay here too? I believe that would be a sensible strategy. Overseas investments-holdings in the corporations of other nations-are not essential, nor even necessary, to a well-diversified portfolio. For investors who disagree-and there are some valid reasons for global investing-I would recommend limiting international investments to a maximum of 20 percent of a global equity portfolio (Bogle 252).

Yet his company, Vanguard currently splits the equity portion of their target date portfolios 60/40 between a total US index fund (VTSAX) and a total international index fund (VTIAX). In fact they have steadily increased the percentage of international stocks from 30% to 40%.

To get the full diversification benefits, we recommend that you consider investing about 40% of your stock allocation in international stocks and about 30% of your bond allocation in international bonds. (Vanguard website [2])

On page 20 of his 2013 annual shareholder letter[3] Warren Buffett omits international funds in his investing strategy for his wife after he passes away. “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

The godfather of personal finance bloggers, Jim Collins, makes the case for 100% VTSAX[4], a total US market index fund instead of diversifying with an international fund.

With this wide range of opinions from these respected experts, what is an individual investor to do?

The Case against International Funds

Different Rules

One of my professors once told us about a professional gambler who visited the gold mines of Minnesota. That night he gambled with the miners and slowly won most of their money after a couple hours. Eventually he had an incredibly strong poker hand and matched as his opponent went all in. He showed his hand, a royal flush, and then his opponent showed his hand, nothing but trash.

He smiled and reached forward to claim his winnings. As he did so, the miners reached towards their guns. He asked what was going on since he had won the hand fair and square. The miners explained that in this county of Minnesota, his opponent actually had a “opokuluza” which always beat all other hands. Though upset, he withdrew and let his opponent take the winnings.

They continued playing throughout the night and by 5 am, since he was a professional gambler, he had won back most of the pot. The next hand was dealt, and he realized he had an “opokuluza”! After the bets were placed he went all in. He showed his hand, chuckling, and reached forward with both arms to claim his winnings. As he was about to sweep the winnings into his bag, he noticed that the miners were about to draw their guns. He declared he had won the hand fair and square. They calmly explained that in this county of Minnesota, an “opokuluza” could only be played once a night and thus he had lost the round and all his money.

The gambler learned that night to avoid gambling with opponents that set the rules. Similarly, investing in international stocks is playing in a field with very different rules and regulations. In the worst cases, some sovereign countries may even set the prices of stocks in businesses that they control. John Bogle, the patron saint of the individual investor for spearheading the first index fund, repeatedly states in his book, Common Sense on Mutual Funds[1], that he wouldn’t suggest investing more than 20% of his equity portfolio in international funds:

If our diamond lode is within our own borders, shouldn’t the investments we choose for our portfolios stay here too? I believe that would be a sensible strategy. Overseas investments–holdings in the corporations of other nations are not essential, nor even necessary, to a well-diversified portfolio. For investors who disagree–and there are some valid reasons for global investing–I would recommend limiting international investments to a maximum of 20 percent of a global equity portfolio (Bogle 252).

Yet his company, Vanguard currently splits the equity portion of their target date portfolios 60/40 between a total US index fund (VTSAX) and a total international index fund (VTIAX). In fact they have steadily increased the percentage of international stocks from 30% to 40%.

To get the full diversification benefits, we recommend that you consider investing about 40% of your stock allocation in international stocks and about 30% of your bond allocation in international bonds. (Vanguard website [2])

In page 20 of his 2013 annual shareholder letter[3] Warren Buffett omits international funds in his investing strategy for his wife after he passes away. “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

The godfather of personal finance bloggers, Jim Collins, makes the case for 100% VTSAX[4], a total US market index fund instead of diversifying with an international fund.

With this wide range of opinions from these respected experts, what is an individual investor to do?

The Case against International Funds

Different Rules

One of my professors once told us about a professional gambler who visited the gold mines of Minnesota. That night he gambled with the miners and slowly won most of their money after a couple hours. Eventually he had an incredibly strong poker hand and matched as his opponent went all in. He showed his hand, a royal flush, and then his opponent showed his hand, nothing but trash.

He smiled and reached forward to claim his winnings. As he did so, the miners reached towards their guns. He asked what was going on since he had won the hand fair and square. The miners explained that in this county of Minnesota, his opponent actually had a “opokuluza” which always beat all other hands. Though upset, he withdrew and let his opponent take the winnings.

They continued playing throughout the night and by 5 am, since he was a professional gambler, he had won back most of the pot. The next hand was dealt, and he realized he had an “opokuluza”! After the bets were placed he went all in. He showed his hand, chuckling, and reached forward with both arms to claim his winnings. As he was about to sweep the winnings into his bag, he noticed that the miners were about to draw their guns. He declared he had won the hand fair and square. They calmly explained that in this county of Minnesota, an “opokuluza” could only be played once a night and thus he had lost the round and all his money.

The gambler learned that night to avoid gambling with opponents that set the rules. Similarly, investing in international stocks is playing in a field with very different rules and regulations. In the worst cases, some sovereign countries may even set the prices of stocks in businesses that they control.

Scott Trench, from Bigger Pockets, often recalls his foray into investing in a China based company where according to their financial documents, their cash was greater than their current market capitalization (the sum of the worth of all their stock). He bought in only to lose money in the midst of the US bull market in the early 2010s. He soon learned, as many other investors had, that accounting rules in China were much less stringent than those in the United States.

Currency Risk

The strength of international markets is relative to the strength of the dollar. If the dollar weakens, international market returns can be exaggerated. For example in the decade that ended in 1994, international stocks had outperformed by a cumulative 137% as measured in US dollars. Yet measured in local currencies, US stocks had actually beaten international stocks by 119%. Investors in the stock market have to take on market risk. For better or usually worse, investors can choose to take style risk and manager risk. If they choose, investors can also take on currency risk.

Globalization of US Companies

Thanks the increasing use of mobile devices and the Internet, global business has exploded.

For the 50 largest U.S. companies, [Vanguard] found that conducted 57% of its business outside of the United States. (3)

Thus, even without assuming currency risk and the risk of international accounting rules, we are already getting global diversification.

Higher Expense Ratios

Although expense ratios continue to fall[6], Vanguard’s lowest international index fund (VTIAX) expense ratios are currently 0.11% which is slightly higher than the 0.04% offered by their US counterpart (VTSAX) as of 2018.

The Case for International Funds

Diversification and the Global Efficient Frontier

Using the longest possible period-the entire history of the EAFE Index-as a basis of study reflects a remarkable outcome. From 1960 through 1997, the annual rate of return of the S&P500 Index of US stocks-11.5 percent-was precisely identical to the return of the EAFE Index of international stocks. …, there were a lot of swings to and for between these two categories, but in the long run international investing failed to add any incremental return to U.S. portfolios (Bogle 267-268).

If at the start of this period, we had bought an equal amount of US and international stocks and then rebalanced yearly, we would have beaten an investor who had just chosen US stocks. This is true of any investments with equal returns that are not perfectly correlated.

In fact, Vanguard’s argument for including global funds is simply for diversification based on the correlation between US and international stocks. The counterargument is that the global stock market is increasingly correlated to the US stock market and in times of economic turmoil, they will fall together thus reducing the risk reduction of international diversification. However, the currency risk that was mentioned earlier also helps decrease the correlation between the US and foreign markets.

Although currency movements tend to be unpredictable and can be large, they have historically been uncorrelated to movements in stock prices (12).

The Rising Sun and Reversion to the Mean

The United States stock market has beaten the rest of world since 1920. By good fortune or by skill, the United States has also been on the winning side of every major world war.

Japan had a dominant 43 percent share of the world’s entire market capitalization in the 1980s which is similar to the US’s total market cap today. Yet in the next two decades, their stock market fell and had yet to recover.

Will the United States continue to outperform the rest of the world? With our business practices and focus on entrepreneurship and creativity, we have reason to be optimistic. However, eventually most portfolios revert to the mean. This means that periods of overperformance will be balanced by periods of underperformance. Holding international funds could be a hedge against the United States underperforming over the next few decades.

Other Considerations

Foreign Tax Credit

If you invest in international funds in taxable accounts, you receive a foreign tax credit to reduce your taxable income. Although this is a great reason to keep foreign stocks in your taxable accounts, this is not truly a benefit since you are receiving this deduction because you have already paid foreign taxes on the earnings from these investments. However, this is a good reason to keep foreign stocks in your taxable accounts instead of your tax advantaged accounts.

Conclusion

Will international stocks or US stocks outperform over the next 30 years? I don’t know. John Bogle, Warren Buffett, and Jim Collins hold US stocks and any one of those men have more wisdom and experience than I do. They advocate for simplicity and either a single US total stock market index fund or the S&P500 index fund (which are incredibly similar) are the pinnacle of simplicity with diversification.

Although I understand their desire for simplicity, I also don’t know how the United States will fare over the next 80 years which although I don’t plan to survive for, I need to plan to survive for. Since I currently don’t hold bonds in my target allocation (turns out I own around 2% due to 401k constraints), I use international funds for diversification.

Optimal Allocation

What would the optimal allocation be between US and international stocks?

The maximum historical diversification benefit would have been achieved by allocating approximately 40% of an equity portfolio to non-U.S. equities (although the difference between 30% non-U.S. and 40% non-U.S. is within 0.01%), with a net reduction in volatility of 75 basis points. Allocating 20% of an equity portfolio to non-U.S. stocks would have captured 63 of those 75 basis points, or about 84% of the maximum possible benefit. Allocating 30% to non-U.S. stocks would have captured about 99% of the maximum possible benefit. (6)

This result causes me to lean towards 30% non-U.S. stocks to balance the additional risks while almost maximizing my benefit.

Although such optimization can serve as a reference point, a significant weakness of this analysis is that it is backward-looking and particularly dependent on the time period examined. For example, at different observation dates, the “optimal” allocation to non-U.S stocks has been as low as 20% or as high as 70%. (6)

Fittingly, the author, Christopher B. Philips, reminds us that trying to go for 100% of the benefit is futile just as my attempt to capture 99% of the benefit especially since we have no idea exactly what the future holds.

I think Vanguard sums it up beautifully in their white paper.

Although finance theory dictates that an upper asset allocation limit should be based on the global market capitalization for international equities (currently approximately 51%), we have demonstrated that international allocations exceeding 40% have not historically added significant additional diversification benefit,s particularly accounting for the costs. For many investors, an allocation between 20% and 40% should be considered reasonable, given the historical benefits of diversification. Allocations closer to 40% may be suitable for those investors seeking to be closer to a market-proportional weighting or for those who are hoping to obtain potentially greater diversification benefits and are less concerned with the potential risks and higher costs. On the other hand, allocations closer to 20% may be viewed as offering a greater balance among the benefits of diversification, the risks of currency volatility and higher U.S. to non-U.S. stock correlations, investor preferences, and costs (13).

My Advice

I would recommend anywhere from 20% to 40% in international funds as Vanguard recommends. I also wouldn’t lose sleep over having 0-50% in international funds since both could increase simplicity. For example, William Bernstein recommends 1/3rd US stocks, 1/3rd international stocks, and 1/3rd bonds[7] whereas Jim Collins recommends 100% US stocks.

What I actually do

I currently target 30% international stocks in VTIAX and 70% US stocks in VTSAX with all my VTIAX holdings in a taxable account. According to my Investment Policy Statement, I will target 33% in international funds in retirement since 75% VTSAX, 25% VTIAX, and 25% bonds are nice round numbers.

Resources

References

[1] Common Sense on Mutual Funds by John Bogle

[2] International Investing - Vanguard’s International Investing Page

[3] Berkshire Hathaway’s 2013 Annual Shareholders Letter

[4] Stocks — Part XI: International Funds - jlcollinsnh doesn’t invest internationally

[5] Global equities: Balancing home bias and diversification by Christopher B. Phillips

[6] Thank you John Bogle and Vanguard! The introduction of their low cost index funds continue to drive expense ratios across the industry down.

[7] If You Can - How Millenials Can Get Rich Slowly by William Bernstein