Week 21 Day 4: International Stocks: The Other Half of the World

Imagine only shopping at one store for everything. That is what owning only U.S. stocks is like -- you are betting that one market will always outperform. International stocks provide diversification: when U.S. stocks struggle, foreign stocks often hold up, and vice versa. From 2000-2009, international stocks outperformed U.S. stocks significantly.

The case for international diversification: (1) Valuation opportunity: U.S. stocks trade at a CAPE ratio of 35+ (expensive by historical standards). International developed markets trade at 15-18. Emerging markets at 12-14. The last time the U.S. was this expensive relative to international (2000), the subsequent decade saw international dramatically outperform. (2) Currency diversification: owning foreign stocks denominated in euros, yen, and emerging currencies provides a hedge against a weakening dollar. (3) Sector exposure: international markets have different sector compositions. Europe is heavy in financials, healthcare, and luxury goods. Emerging markets are heavy in technology (Samsung, TSMC, Alibaba) and commodities. Global exposure: VXUS (Vanguard International, 0.07%) holds approximately 8,000 stocks in 46 countries. VWO (Vanguard Emerging Markets, 0.08%) focuses on China, India, Taiwan, Brazil, etc. The counterargument: U.S. companies already earn 40% of revenue abroad. Currency hedging costs money. International markets have weaker shareholder protections. The practical middle ground: 60-70% U.S. / 30-40% international for equities gives you global diversification without completely abandoning the world's most dynamic economy.

The 'home bias puzzle' (French and Poterba, 1991) documents that investors worldwide dramatically overweight domestic stocks relative to global market cap. U.S. investors hold approximately 80% domestic despite the U.S. being 60% of world market cap. The theoretical optimal allocation under mean-variance optimization with reasonable return assumptions is approximately 30-50% international for a U.S. investor (Solnik, 1974; Sercu, 1980). The practical challenge is that international diversification has failed to deliver in recent decades: the correlation between U.S. and international stocks has increased from approximately 0.4 in the 1990s to approximately 0.8 by 2024 (Goetzmann, Li, and Rouwenhorst, 2005, documented this trend). Higher correlation reduces diversification benefits. However, Asness, Israelov, and Liew (2011) showed that relative valuations between U.S. and international stocks are mean-reverting with a half-life of approximately 10 years. With the U.S./international valuation spread at extreme levels (U.S. CAPE 35+ vs. EAFE CAPE 16), the expected return differential favors international by approximately 3-4% annually over the next decade (GMO, Research Affiliates, Bogle Research Center estimates). This does not guarantee international outperformance, but the expected return case for diversification is stronger today than at any point since 2000.