International equity diversification does not protect us very well from stock market losses. This is one message of the falls we’ve seen recently.
So far this year, the All-Share index has fallen almost 7 per cent. But continental European equities are down over 5 per cent in sterling terms, the US over 6 per cent, Japan almost 5 per cent and emerging markets almost 4 per cent. Spreading your equity investments around the world would therefore have mitigated your losses only very slightly.
This fits the long-term pattern: when the UK falls significantly, so too do other markets. Since 1990 we’ve had 34 calendar months in which the All-Share index fell more than 5 per cent. MSCI’s Europe excluding UK index has fallen in every one of these months. Their US and emerging markets indices fell in all but two, and Japan in all but three.
What’s more, average losses in these months have been big. On average, the All-Share index lost 7.5 per cent in these months. But emerging markets and Europe both lost an average of more than 8 per cent, while the US and Japan suffered average losses of more than 6 per cent (all numbers are in sterling terms).
The inference is clear. You cannot spread equity risk well by buying overseas shares. One reason for this is simply that holding UK shares gives you lots of overseas exposure because the All-Share index is dominated by global shares such as HSBC and Royal Dutch Shell. Also, shares in one market tend to be near-substitutes for those in others, which naturally means that if one falls so do others. Plus of course there’s the fact that many shocks to markets such as the financial crisis are global in nature.
Global equity market risk is therefore significant. You can only protect yourself from it by holding non-equity assets such as cash, bonds or gold. And even these are not wholly reliable protectors.
It does not follow, however, that we should abandon overseas markets and stick to UK shares. For one thing, doing so might mean missing out on good returns. Certainly, it has done in recent years. In the past five years MSCI’s world index excluding the UK has risen 55 per cent in sterling terms, while the UK has risen less than 8 per cent. Personally, I suspect the UK will do relatively better soon simply because it is now relatively cheap. But I don’t hold this view with such high confidence as to advocate a 100 per cent weighting to the UK.
Also, there’s a big difference between short-term and long-term equity risk. In the short term, stock markets are driven by changes in global investors’ appetite for risk. These generate large co-movements between national markets. Over longer horizons, however, markets can move because of surprise changes to local economic growth or changes in valuations. These can generate moves in different directions in different countries. And this, says Cliff Asness of AQR Capital Management, means that international diversification can work for investors worried about risk over longer terms.
For example, in the five years to October 2003 the All-Share index fell 20 per cent. But during this time emerging markets rose 40 per cent. And in the five years to February 2009 the UK fell 16 per cent while Japan and emerging markets rose. In these periods, spreading your equity investment around the world would have mitigated losses.
Younger investors have another reason to invest overseas. If you work in the UK then holding UK equities means you are to some extent putting all your eggs in one basket. This is because if the UK economy does badly not only will you lose on your equity holdings but you’ll also suffer falls in real wages and worse job prospects. Investing overseas might therefore diversify your human capital risk, especially over long periods. In recent years large overseas investments would have done a better job than domestic equities of offsetting the fall in real UK wages. And Japanese investors during the country’s 'lost decades' of the 1990s and 2000s would have enjoyed profits on overseas equities to offset stagnant wages.
There are, therefore, strong reasons for investing in overseas equities. Just don’t think that doing so protects you from short-term equity risk. It doesn’t.
