“Free Lunch” Investing Takes Time to Cook


As the director of research for The BAM Alliance, I’ve been getting lots of calls recently from investors questioning their international equity investments. This hasn’t been a surprise, as any time an asset class does poorly, a significant number of investors will question why they own that asset.

One particular inquiry I received addressed the fact that international equities not only had underperformed since 2009, but they crashed in 2008—just when the benefits from diversification were needed most, they failed to materialize. The investor thus questioned the reason for including international equities in his portfolio.

Among the errors discussed in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” is one called recency. Recency is the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to buy after periods of strong performance (when valuations are higher and expected returns are now lower) and sell after periods of poor performance (when prices are lower and expected returns are now higher). This results in the opposite of what a disciplined investor should be doing: rebalancing to maintain their portfolio’s asset allocation.

The problem created by recency is compounded when international stocks underperform, greatly increasing the risk that an investor will commit a mistake. This occurs because of another common error: confusing familiarity with safety, which leads to a home-country bias.

To address the question of where to find the benefits of international investing, we don’t have to go back too far in time. The problem is that investor memories can be very short—often much shorter than is required to be a successful investor.

A Time Of Crisis And Recovery

We’ll begin our analysis by looking at the period that’s caused investors to question their strategy of global diversification: 2008 through September 2016. Over this period, the S&P 500 Index returned 6.9% per year, the MSCI EAFE Index returned -0.3% per year and the MSCI Emerging Markets Index lost 1.2% per year. Given these results, it’s easy to understand why investors are questioning their strategy.

But no one was questioning this strategy during the prior seven-year period: 2001 through 2007. During this period, the S&P 500 Index returned 3.3% per year, the MSCI EAFE Index returned 8.8% per year and, lastly, the MSCI Emerging Markets Index returned 24.0% per year.

For the full period 2001 through September 2016, the S&P 500 Index returned 5.3% per year, the MSCI EAFE Index returned 3.5% per year and the MSCI Emerging Markets Index returned 9.1% per year. A portfolio allocated 60% to the S&P 500, 30% to the MSCI EAFE Index and the remaining 10% to the MSCI Emerging Markets Index (and then rebalanced quarterly) would have returned the very same 5.3% with just slightly higher volatility (15.6%) than the S&P 500 Index (14.8%).

The table below, covering the five-year period 2003 through 2007, presents an even more compelling case for international diversification. You can be sure I wasn’t getting any calls about diversifying internationally during this time, except of course for the ones from investors asking why their allocation to international stocks wasn’t higher! (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)


Over this particular five-year period, the S&P 500 Index underperformed by anywhere from 8.8 percentage points per year to as much as 32.4 percentage points per year. However, a tree can’t grow to the sky, and such outperformance cannot persist. Inevitably, the high returns produced by international stocks can lead to high valuations and, thus, to lower future returns (and vice versa). And that’s the situation we have today, as the data in the following table demonstrates.


Forward-Looking (Expected) Returns

Many investors are questioning the benefits of international diversification at a time when U.S. equity valuations are now quite a bit higher than international valuations. And because current valuations are the best predictor we have of future returns, international investments now have higher expected returns. At the end of September 2016, the Shiller CAPE 10 ratio for the S&P 500, which uses the last 10 years’ earnings (adjusted for inflation), produced an earnings yield (or E/P, the inverse of the P/E ratio) of about 3.7%.

To adjust for the fact that real earnings grow over time, and for the fact that we are looking at earnings on average five years old, we need to multiply the earnings yield by 1.1, producing a new earnings yield, and a forecast of expected real return, of about 4.1% for the S&P 500. The CAPE 10 ratio for the MSCI EAFE Index produces an earnings yield of about 6.7%, resulting in an expected real return for the stocks in that index of about 7.4%. And the CAPE 10 ratio for the MSCI Emerging Markets Index produces an earnings yield of about 7.3%, resulting in an expected real return for the stocks within that index of approximately 8.0%.

Using this metric, we see that U.S. stocks should be expected to underperform developed markets stocks by 3.3 percentage points and emerging markets stocks by 3.9 percentage points.

Of course, these are just estimates of expected returns. Even though the evidence suggests that this is as good a predictor as we have, the methodology explains only about 40% of actual future returns. The rest comes from unexpected events (earnings grow faster or slower than expected and valuations change).

Thus, we must be very humble about how we think about such forecasts. By that I mean we shouldn’t treat them as single-point estimates. With U.S. stocks, based on the historical evidence, to include all actual subsequent outcomes, you would have to both add and subtract about 8% from the expected real return.

In other words, while the mean expected real return for the S&P 500 Index going forward is 4.1%, potential outcomes range from a real loss of about 4% to a real gain of about 12%. That’s a very wide dispersion of potential outcomes. It also shows how difficult it is to forecast returns.

Before moving on, the table below shows various value metrics for three of Vanguard’s index funds. The historical evidence is that higher valuations forecast lower future returns. The data is from Morningstar as of Aug. 31, 2016.


As you can see, regardless of the value metric we observe, the valuations of U.S. stocks are now much higher than international valuations, especially emerging market valuations. Now, it’s important to understand that this doesn’t necessarily make international investments a better choice. Their higher valuations simply reflect the fact that investors view the United States as a safer place to invest. And there is an inverse relationship between risk and expected returns (at least there should be).

Making The Case For Global Diversification

Diversification has been rightly called the only free lunch in investing—a portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country owned in isolation.

However, as we have been discussing, the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose toward one. Many investors took the wrong lessons from what happened, wrongly concluding that global diversification doesn’t work because it fails when its benefits are needed most. This is erroneous on two fronts.

First, a critical lesson is that, because the correlations of risky assets tend to rise toward 1 during systemic global crises, the most important diversification is to ensure your portfolio has a sufficiently large allocation to safe bond investments (investments such as U.S. Treasury bonds, FDIC-insured CDs and municipal bonds rated AAA/AA) so that the overall portfolio’s risk is dampened to the level appropriate for your ability, willingness and need to take risk.

During systemic financial crises, the correlations of the safest bonds to stocks, while averaging about zero over the long term, tend to turn sharply negative (when they’re needed most) because they benefit not only from flights to safety, but also from flights to liquidity.

Another wrong lesson investors took from the 2008 financial crisis involves a failure to understand that, while international diversification doesn’t necessarily work in the short term, it does work eventually. This point was the focus of a paper by Clifford Asness, Roni Israelov and John Liew, “International Diversification Works (Eventually),” which appeared in the May/June 2011 edition of Financial Analysts Journal.

Diversification No Refuge In The Short Term

The authors explained that investors focused on the fact that globally diversified portfolios don’t protect them from short, systematic crashes miss the greater point that those with a long-term planning horizon (and it should be, or you shouldn’t be invested in stocks to begin with) should care much more about long, drawn-out bear markets that can be significantly more damaging to wealth.

In their study, which covered the period 1950 through 2008 and 22 developed-market countries, the authors examined the benefits of diversification over a long-term holding period. They found that over the long run, markets don’t exhibit the same tendency to suffer or crash together. Thus, investors shouldn’t allow short-term failures to blind them to long-term benefits.

To demonstrate this point, they decomposed returns into two pieces: (1) a component due to multiple expansions (or contractions); and (2) a component due to economic performance. The authors found that while short-term stock returns tend to be dominated by the first component, long-term stock returns tend to be dominated by the second.

They explained that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns.”

In addition, the authors showed that “countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns.”

For example, in terms of worst-case performances, they found that at a one-month holding period, there was little difference in the performance between home-country portfolios and the global portfolio. As the horizon lengthens, the gap widens. The worst cases for the global portfolio were significantly better (meaning the losses were much smaller) than the worst cases for the local portfolios. The longer the horizon, the wider the gap favoring the global portfolio becomes.

Demonstrating the point that long-term returns are more about a country’s economic performance and that long-term economic performance is quite variable across countries, the authors found that “country-specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time.”


The conclusion you should draw is that while global diversification can disappoint over the short term, over the long term, which is far more relevant, it should be expected to be the free (and hearty) lunch that theory and common sense say it should be.

If you require a more specific example of the wisdom of this advice, look to Japan. The poor returns that Japan has experienced since 1990 weren’t a result of systemic global risks. It happened because of Japan’s idiosyncratic problems. And before you make the mistake of confusing the familiar with the safe, you cannot know which country or countries will experience a prolonged period of underperformance. And that uncertainty is what international diversification protects you against.

Finally, the ability to avoid making the twin mistakes of recency and of confusing the familiar with the safe are key aspects to being a successful investor. Warren Buffett offered the following advice, which is related to our discussion: “The most important quality for an investor is temperament, not intellect.” You must be able to ignore short-term performance if you hope to gain long-term benefits. And as we just showed, even seven years is short term when it comes to investing.

This commentary originally appeared October 17 on ETF.com

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