In the 17th century, French philosopher Blaise Pascal concluded that it was impossible to persuade skeptics to believe in God through reason. Instead, he urged them to bet in favor of faith. They had nothing to lose by believing and everything to gain if it turned out they'd made the right choice, he said.
These days, many U.S. investors must feel like Pascal's nonbelievers when they hear investment advisers say they need a healthy mix of foreign stocks in their portfolios. And--despite the temporal subject--the arguments sound remarkably similar. Essentially, they're asking investors to have faith in a tenet of portfolio theory that hasn't been convincing in recent years: the idea that adding international stocks to a domestic portfolio enhances returns and reduces risk long-term because foreign markets' trends offset those of the U.S.
Certainly, no one could blame U.S. investors for doubting the virtues of sending their money abroad. Over the past decade, the U.S. market has dramatically outperformed the developed foreign-market benchmark, the Morgan Stanley Capital International Europe Australasia and Far East Index (chart). Annualized returns for the Standard & Poor's 500-stock index were 17.47% from 1991-2000, more than doubling the 8.52% earned by an EAFE portfolio. In dollars, the Nikkei fell 2.35% a year on average during that period. Even in 2001, a miserable market year all around, the S&P's 10.68% drop as of Aug. 27 is beating EAFE's 26.59% decline.
The U.S. dollar's strength against the euro (and its predecessors) and other foreign currencies since the mid-'90s has also made foreign stocks a tougher sell. A U.S. investor can lose money on rising British or Japanese stocks if the pound or yen fall against the dollar.
Investment gurus began preaching the international investing gospel in the 1970s, when the U.S. was in an extended bear market. It made sense then. The dollar was weak, and the S&P returned an average of only 8.45% annually, vs. 13.78% for the EAFE during the decade. In the 1980s, the U.S. bull market took hold, but stocks in Japan and Western Europe did even better, especially after the dollar collapsed from its mid-decade peak.
Then came the 1990s. European stocks, benefitting from ongoing economic unification, were relatively strong. But overall results from the EAFE index were depressed by the collapse of Japan's highflying market and the 11-year economic slump in which it's still stuck. Weak foreign currencies eroded U.S. investors' returns even more.
Disappointed with recent results, many investors have forgotten the stellar returns of earlier decades. Many question whether international diversification remains a valid concept. "From the point of view of the U.S. investor, who has tremendous opportunities to diversify at home, international investing has been oversold," says Robert Z. Aliber, professor of international economics and finance at the University of Chicago. Even if foreign investments outperform domestic ones, he adds, higher fees eat up the extra return.
"PHONY ARGUMENT." Others say you can get the benefits of international diversification without the headaches of foreign stock ownership by investing in U.S. companies that do much of their business abroad. That way, you get exposure to non-U.S. economies but with the protection of U.S. securities regulation, says Roy Papp, whose Papp America-Abroad Fund does just that. He also dismisses as a "phony argument" the notion that global diversification reduces risk because movements in one market offset those in another. Thanks to globalization, he points out, markets increasingly move in tandem.
It's an eternal truth that when investors start doubting or even dismissing an investment strategy, it's about to come back into fashion--and profitability. If nothing else, the dollar, long a drag on foreign returns, is starting to weaken. "That's positive for U.S. investors," says Barton Biggs, global investment strategist for Morgan Stanley. "Instead of having the wind in their face and losing money on overseas investments [from the strong dollar], they'll benefit." Biggs foresees a two- to three-year period of dollar weakness.
What's more, some global strategists argue that many foreign companies are better buys than their U.S. counterparts. Even with the U.S. market down, the past 12 months' price-earnings ratio for the S&P 500 is 33, while Bloomberg's European 500 Index of the continent's biggest companies by market weight is valued at 22.
Another case for diversifying: The U.S. can't outperform forever. So hedge your bets. "Diversification assumes you don't know which country is going to be the best performer for the next 10 years," says Ernie Ankrim, director of portfolio strategy at Russell Investment Group. In other words, "long-term diversification always results in better returns than the worst performer for any market."
Perhaps the best case for globalizing your portfolio is that over the very long term, say, 30 years, there's no opportunity cost vs. having kept all your money at home. The 30-year average returns for U.S. and international investing are nearly identical--14.12% for the S&P, vs. 14.21% for EAFE.
There was lots of year-to-year volatility under those averages. The S&P ranged from -26.5% to 37.4%, and EAFE veered from -23.2% to 69.9%. But diversification helps lessen risk in your holdings. According to Russell, a portfolio that was two-thirds invested in the S&P 500 and one-third in EAFE had a 30-year average annual return of 14.08%--a hair less than either an all-U.S. or an all-EAFE portfolio. But the blended portfolio was less volatile than either, when measured by the year-to-year fluctuations in value.
Salvation, not international investment diversification, was Pascal's main concern in the 17th century. But if he were alive today and pondering portfolio theory instead of religion, he might well find himself preaching a version of his bet to doubting U.S. investors.
By Julia Lichtblau
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