Looking to boost your investment returns and lower your risk? Try looking overseas. International stocks offer better value than their U.S. counterparts on a variety of time-tested measures. And, contrary to received wisdom, if you invest globally in a sensible manner you’ll reduce the risk to your portfolio, not increase it. In the past 12 months, the U.S. stock market—as measured by the standard MSCI US Equity index—has risen about 16% and is hovering around all-time highs.
The story overseas has been more mixed. While Europe overall is also up about 16%, Spain has soared 33% and Italy nearly as much. Meanwhile, Japan is down 4%, and the main indexes of many “emerging markets,” such as Brazil and Thailand, have slumped by around 10%. The U.S. equity market is now among the most expensive in the world when you compare stock prices to company fundamentals such as per-share earnings, dividends and net assets.
For example, U.S. stocks overall trade for 16 times forecast per-share earnings for the next 12 months. The average outside the U.S.: lower than 13 times. U.S. stocks offer a dividend yield of 1.7%, meaning this year you should expect just $1.70 in dividends for every $100 worth of stocks you own. That will barely keep up with inflation. Overseas markets on average pay 2.8%.
Foreign markets that are considerably cheaper than the U.S. by these measures include such diverse names as Hong Kong, Japan, Singapore, Germany, France, Norway, the U.K. and Brazil. Better valuations today usually lead to better investment returns down the stretch. Mebane Faber, chief investment officer of El Segundo, Calif.-based Cambria Investment Management, has studied how investors have fared around the world over many decades and reached a remarkably simple conclusion.
Put to one side fears about “risks” and forecasts for this year’s or next year’s returns. Since 1975, he found, you would have made enormous profits simply by investing each year in the world’s cheapest markets and avoiding the most expensive. So if you had invested $1,000 in a global stock index in 1975 and just left the money there, reinvesting dividends, over the next 36 years your money would have grown to $74,000. That’s an annual return of 12.7%. But if you had invested instead each year in the 10% of world markets that were the cheapest in relation to company net assets, you would have ended up with rather more: $400,000. That’s an annual return of 18.1%. (Neither figure is adjusted for inflation.)
U.S. stocks are expensive because investors have become increasingly optimistic about the U.S. economy and the continuing boom in corporate profits. The Federal Reserve has bolstered the enthusiasm by pumping liquidity into the financial system in recent years. Is that optimism misplaced? Maybe. But it doesn’t really matter. What matters is how far that optimism is already reflected in the high price of stocks. The world economy is increasingly global, so U.S. corporations are exposed to booms and busts overseas—and vice versa. A U.S. economic boom would be good for companies in Japan, and a slump in Asia, for example, would be bad for U.S. companies. Three years ago, global investors were similarly optimistic about the boom in emerging markets, and sent share prices in places such as Brazil and India soaring. Since then, growth in those countries has disappointed.
Emerging markets have also been hit by political turmoil and in some cases by inflation. The stocks, which had been priced to reflect good news, have come tumbling down. Investors can try to capitalize on lower valuations in many overseas markets by investing in mutual funds or exchange-traded funds that invest in individual countries, such as the iShares MSCI Germany Index or iShares MSCI Japan Index ETFs. But for many investors, that strategy would be too aggressive, too complicated and too costly.
A simpler strategy is to hold more of your investments in a global portfolio of U.S. and overseas stocks and to rebalance it every quarter or every year.
Many investors are encouraged to hold perhaps 80% of their money in U.S. stocks and maybe 20% in international issues. This is the wrong way ’round. The U.S. now accounts for a little more than 20% of the global economy. A more sensible allocation might be to invest one-third of your money in the U.S. stock market, one third in developed international markets—such as a fund that tracks the Europe, Australasia and Far East (EAFE) index—and the remaining third in the MSCI Emerging Markets index. This strategy gives you access to an array of low-cost mutual funds and exchange-traded funds that invest in each of these indexes. To be sure, there is a “currency risk” to overseas investments. Foreign currencies may weaken against the dollar, reducing the dollar value of a U.S. investment.
But this risk is usually overstated. Foreign currencies are just as likely to strengthen as they are to weaken. And local stock prices tend, over time, to compensate for currency fluctuations, rising if the currency falls and vice versa.
Conventional wisdom says that international stocks are riskier than U.S. shares and that you should severely limit your exposure to them, especially if you have what brokers call a “low tolerance for risk.” It’s a mantra repeated frequently by investment managers, but repetition doesn’t make it true.
Conventional wisdom works for professional money managers because it limits their legal liability if things go wrong. But a private investor acting on his or her own can do better.