Why NOT to Ignore International Stocks

Due to recent world events with the Russian invasion of Ukraine, many investors are likely shying away from international stocks, and who could blame them! The Russian stock market has closed down for over a week, marking significant liquidity concerns for investors in Russian and international securities as a whole. This is alarming to read in the news, but I want to show you why not only is this likely of little concern to your portfolio, but also that it should not dissuade you from allocating a portion of your portfolio to international stocks in both developed and emerging markets.

First, let's take a look at what the Russian invasion of Ukraine has meant for international markets and how much exposure most indices have to Russian and Ukrainian stocks. Below is the breakdown of the percentages of Russian and Ukrainian stocks held in each type of Vanguard fund.

Vanguard International Stock Indices Percentage Exposure to Russian and Ukrainian Stocks

The average Target Date Retirement Fund will hold around 30-35% of an international stock index at most for an investor that is in 100% stocks. On average, most US investors only have 15% of their holdings in international companies, which is a mistake. But let's assume an investor has 35% of their money in the Total International stock ETF above. Right now, Russian markets are frozen being down 32%, but let's assume they are worthless when the market opens and they are down 100%. That means for that investor that is heavily invested internationally, the maximum worst-case scenario effect of Russian markets ceasing to exist is a total 0.28% effect on his or her portfolio. Now, International markets as a whole have decreased recently due to these events having an impact on the global economy, but the exposure and impact of Russian stocks alone to most portfolios is minimal. Most investors would have an even lower impact due to holding fewer international stocks and some allocation to bonds.  

Now, why would it be a mistake to get spooked by recent events and decrease your holdings in international stocks or even to avoid them entirely? Well, most all investors fall prey to something called home country bias. This is a bias that says investors hold disproportionate amounts of domestic equities in their portfolios. This means U.S. investors tend to weigh towards U.S. stocks, while Australian investors tend to weigh towards Australian stocks and so forth. The below graph from a Vanguard survey in 2014 shows that this bias exists across almost every country.

It is important to be aware of this bias and combat this by investing in a globally diversified portfolio and sticking to it over long periods, regardless of the news cycle. This includes a healthy allocation to an international stock index or two. This is important for 2 reasons:

1. Diversification. This has become almost a buzzword in finance and investing these days but it hasn't become any less important. Having an investment portfolio that is well-diversified and has asset classes that zig when others zag is a highly underrated aspect of a portfolio. According to an asset correlation matrix from Morningstar, foreign industrialized stocks have between a 51% and 58% correlation with U.S. stocks. This means that they move in the same direction as U.S. stocks around half the time. This is important to have this diversification because it has the potential to decrease portfolio volatility while maintaining portfolio return. Holding an international stock market index in both developed and emerging markets also allows you to diversify your investments between international countries. These indexes are comprised of companies in many countries across the world. The Russian invasion of Ukraine is a great example of this because it shows how even though the Russian markets have tanked by 50%, the Vanguard Total International Stock Market Index (VTIAX) is only down 5.39% from February 24, 2022, to March 14, 2022. The Vanguard Total Stock Market Index (VTSAX) is down only 3.09% over that same period. Even during some of the most tumultuous times in global history, diversification is what insulates your portfolio from more wild swings.

2. Valuation: The best and most widely used metric of valuation is the P/E ratio or price to earnings ratio. This ratio measures the price of the stock or index divided by its earnings. A higher P/E ratio indicates a more expensive stock, while a lower ratio indicates a less expensive stock. The S&P 500 which represents the 500 largest stocks in the United States currently has a P/E ratio of 24.08. This is fairly high historically when shown on the graph below since 1870.

Historical P/E Ratio of the S&P 500 (https://www.multpl.com/s-p-500-pe-ratio)

The P/E ratio of the Vanguard Total International Stock Market Index (VTIAX) is just 14.18, much lower than that of the S&P500. The Vanguard Emerging Markets Index (VEMAX) has a P/E ratio of just 12.37. The lower ratio of the international indices indicates that international stocks are much more affordable and can be purchased at more attractive valuations than U.S. stocks. Another way to say this is that investors don't have to pay as much for the earnings of those international companies as they do for earnings of U.S. companies. There are many reasons for this, but it generally boils down to the United States being a highly advanced, industrialized nation that has grown rapidly and has used technology to become a global superpower. This has created many companies such as Apple, Amazon, Facebook, and Google, that are powering the S&P 500 and have stock prices that have shot through the roof over the last decade. These are what are considered "growth" stocks that have very high P/E ratios, indicating they are very expensive stocks to investors for the earnings that these companies produce. Other countries such as Japan, Great Britain, and Canada don't have as many fast-growing companies like this and have economies that are years behind that of the United States in many ways. They have more companies with lower P/E ratios that can be bought at much more attractive valuations than many of the large U.S. companies.

To show how this can play out in the markets, let's look at an example. Below are the returns of the Vanguard Total Stock Market Index and the Schwab International Index from January 2001 to January 2008. This is a period that is commonly referred to as the "lost decade" for U.S. investors. Looking at the below,  you will see that during this period, international stocks outperformed U.S. stocks by 3.37% on an annual basis. I realize that this is a cherry-picked period where the international markets outperformed the U.S. markets, but it just shows that U.S. markets will not always outperform as they have in the past decade, and it is nearly impossible to know when the time of underperformance is coming. The S&P 500 has outperformed international indices by a large margin over the last decade. We could see something happen like the below, or we could continue to see outperformance by U.S. stocks.

Right now it is more important than ever to stay committed to a globally diversified portfolio. Making moves in your portfolio based on global events is a form of market timing that has shown to be a losing proposition. U.S. stocks have outperformed international stocks in recent years, and it is absolutely impossible to predict when that will end or how long that will continue. What I do know is that blindly ignoring 40% of the world stock market is not the smartest decision. The United States has one of the most advanced economies in the world and continues to be a great bet for investors, but there are many countries out there that have so much room to grow and provide great returns to investors. Allocating a healthy portion of your equity portfolio toward developed international stocks (around 15-25%) as well as emerging international stocks (around 7-10%) is a great step in the right direction toward proper global diversification. Not only will this diversification likely help to decrease portfolio volatility, but it could also boost returns as it provides rebalancing opportunities and lowers the P/E ratio of your portfolio, which could lead to higher returns over the long run. At the end of the day, it is about being convicted about following an evidence-based portfolio through thick and thin. I hope this analysis showed why international stocks should be a part of that portfolio, even during some of the most trying times in history for our world.