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Why invest overseas?

International diversification is little use in the short term, but important for longer-term investors
June 30, 2020

Investors should spread their equity investments around the world – but not perhaps for the reason you might think.

International diversification is no way to spread short-term equity risk. In March, for example, the All-Share index fell more than 13 per cent as the pandemic struck. But emerging markets fell as much, and US and continental European markets fell more than 10 per cent in sterling terms – falls that were cushioned by the drop in the pound. Wherever you had invested, you lost money quickly.

Such co-movement is typical. If we look at monthly price moves in sterling terms since 1997 the correlation between UK and US stocks has been 0.79 and that between UK stocks and MSCI’s Europe ex UK index has been 0.87. Such big numbers tell us that major stock markets rise and fall together in the short term. You cannot therefore reduce short-term equity risk much by spreading your investments overseas. If you want protection against such risks, you need non-equity assets such as cash, bonds, gold or foreign currency.

All this, however, is true only for short-term moves. If we look at longer-term returns, we find a case for international diversification.

Take the past 10 years. In this time, the All-Share index has risen barely 10 per cent (although it has done much better if you had reinvested dividends). But continental European and Japanese stocks have risen more than 60 per cent and the S&P has tripled in sterling terms.

And the past 10 years are not terribly unusual in seeing large differences in returns. In the 10 years to 2010 UK and US equities fell, but emerging markets tripled. And in the 10 years to 2007, European stocks outperformed the UK and US by 60 percentage points.

 

 

International diversification thus protects us from the risk that the UK (or any other market) will hugely underperform over the long run. And this risk is significant.

But what causes it? It’s not always differences in economic growth. In the past 10 years the UK’s real GDP has actually grown by more than Japan’s or the eurozone’s. But this didn’t stop the UK market underperforming. Which reminds us that there’s little correlation across countries between long-term growth and long-term equity returns, as MSCI economists and the University of Florida’s Jay Ritter have shown.

That said, there is a danger that we could see both a weak economy and poor equity returns over the long run, as we saw in Japan in the 1990s. This is an especial reason for younger people to diversify internationally. Doing so protects you from the danger that you’ll suffer both poor investment returns and bad career prospects. You might think this is a slim chance. But investors must always be on guard against low-probability/high-cost risks. Given that there is a danger of ongoing stagnation in western economies generally, this is perhaps the strongest reason for longer-term investors to look to emerging markets.

There are other reasons why returns differ over the long run.

One is that national stock markets have different sector weightings. One reason for the UK’s underperformance is that it is light in sectors that have had a good decade, such as technology, but heavily exposed to ones that have done badly, such as oil companies, miners and banks.

Also, there are cross-country differences in changes in the balance of class power: New York University’s Sydney Ludvigson has shown that these matter enormously for long-term returns. One reason why the US has done so well in recent years has been the rise of monopoly power for some companies at the expense of workers. In the same way, the UK outperformed the US in the late 1970s and early 1980s as trade union power declined and profit margins recovered.

And then there are valuations, which can influence returns even over long periods. One reason for the US’s lacklustre performance in the 2000s was that the tech bubble had left the market overvalued and it took years for this to be corrected.  

Which brings us to a reason not to neglect the UK entirely. A decade of underperformance has left the All-Share index looking cheap. Sure, there are good reasons for such cheapness. A disproportionate share of the market is in companies that might have gone ex-growth: if the world economy does shift towards greener growth, oil and mining companies are in for a rough time. And it’s possible that post-Brexit trade barriers will depress the earnings of domestically-oriented stocks for a long time. But it could be – indeed should be if markets are nearly efficient – that these prospects are already in the price.

Yes, we must diversify internationally. But in doing so we must not neglect the merits of dear old Blighty entirely.