International diversification: The evidence – Part 2

In the previous post we saw that international diversification:

  • Helps ensure one country’s drawdowns don’t affect your overall portfolio’s returns too much,
  • Reduces risk through lower volatility, drawdowns, and vulnerability to Black Swans,
  • Increases returns through minimising the volatility tax and owning the few countries which are driving returns.

But that’s not all…

Diversification reduces sector risk


Were an investor to only invest in their own country’s stock market, they’d be taking some large sector bets, no matter where they were from.

The table below shows a selection of countries along with their local index’s sector weights:

Sector breakdown by countrySource: Bloomberg

By investing in any single country, you’re taking some heavy sector bets. If you lived in China, you’d have to be very confident that the financials sector was going to outperform, given it’s 40% of their market. If you lived in Switzerland, you’d have to be confident that energy stocks were going to underperform, given that the Swiss stock market doesn’t have any energy stocks at all.   

By only investing in your home market you’re not only taking on sector risk, but by focusing on one country you’re neglecting other countries which are dominant forces in particular sectors. For example, European pharmaceutical companies are among the world’s leading players, including Novartis, AstraZeneca and Novo Nordisk. The luxury goods industry is another example, centred in France, Italy and Switzerland with companies such as LVMH, Kering and Richemont.

Outside Europe, the story remains just as valid. Japan is home to many cutting-edge robotics firms, including Murata and FANUC. Some of the world’s most successful technology companies are based in Asia, including Samsung, Tencent and Alibaba.

While sector classifications can show some extreme deviations from other countries, it’s worth caveating that GICS sector classifications aren’t constant and can change over time. In 2018 Alphabet moved from the technology sector to the communications sector, Facebook also moved from technology to communications, as did Nintendo. Both Alibaba and eBay moved from technology to consumer discretionary.

I’ve used GICS sectors here as a best approximation. It matters less what sectors you can gain access to from investing overseas according to GICS, and more that overseas companies are likely to do different things than the ones in your home market.  

Diversification reduces valuation risk


The evidence shows that valuations matter to long-term returns. The higher the valuation, the lower the long-term returns.

The chart below shows that in short-term, valuations have almost no impact on returns, but become increasingly important for returns in the longer-term:

Valuations vs long term returns

Source: JP Morgan

I’ve only included the one chart from JP Morgan, but there’s a huge amount of evidence to back up this conclusion. I’ll cover all the evidence in another post, but for now, the main point is that higher valuations equal lower long-term returns.

Countries’ valuations can rise and fall, just as stocks’ valuations can rise and fall. This means countries can become overvalued just as stocks can.

Much of a country’s valuation is determined by the dominant sectors in the country’s stock market. As we saw in the previous section, the sector exposure can vary quite dramatically between countries. This affect’s a country’s valuation, which affects its returns.

Research from Capital Group has shown that when comparing the US market to the rest of the world, international indices generally have a greater concentration of value stocks in sectors such as materials, financials and energy compared to the US, where growth stocks in the technology and health care sectors dominate the S&P 500.

That alone accounts for much of the return disparity between US and non-US stocks:

US vs non-us sector breakdowns

Source: Capital Group

Rather than just look at US/ex-US, we can drill down into an individual country level. Research from Star Capital shows just how varied valuations across the world can be. The following table shows each country along with its weighting in the global index and several different ways of measuring the country’s valuation – CAPE, P/E, P/CF, P/B, P/S, dividend yield, and two relative-strength indicators. It then ranks each country from cheapest to most expensive based on a blend of the valuation metrics:

Country valuations

Source: Star Capital

CAPE ratios range from 58.3 in Ireland to -3.2 in Greece, price-to-cashflow ratios range from 16.4 in New Zealand to 4.8 in Russia, and price-to-book ratios range from 3.6 in the US to 0.9 in Greece. It’s fair to say that there’s a large dispersion in valuations around the world.

It makes no sense to take a significant bet on any single country when there’s such a wide range of valuations and hence such a wide range of expected returns.

By diversifying internationally, you reduce your exposure to long-term returns based off a single valuation – your home country’s.  It helps investors living in richly valued countries increase their return expectations by allocating more to countries with lower valuations, and helps those living in countries with lower valuations diversify their value-biased portfolios by increasing their allocation to growth-oriented sectors.

Where a company is listed is becoming irrelevant


Although the valuations of a country’s stocks affect the country’s future returns, the fact that those stocks are listed in that particular country is becoming increasingly meaningless.

The table below shows the percentage of each country’s revenues which are generated from their home country versus from overseas:

Percentage of revenue earned domestically

Source: Morningstar

Increased globalisation means that it matters less and less where a company is listed, as more companies are able to do business all over the world. 38% of the US market’s revenues come from outside the US. The tobacco company Philip Morris International, for example, has long been one of the largest stocks in the S&P 500 without ever having any US revenues. Similarly, 78% of the FTSE 100’s revenues are derived from outside the UK, and the 10 largest companies in Europe generate less than a third of their revenue from their home region:

Revenue exposure of European companiesSource: Capital Group

Given that companies manufacture, trade, and sell goods all over the world, it matters less and less where a company chooses to base itself.

When thinking about investing in your local market versus investing globally, does it really make sense to restrict your choice of investments to those companies which happened to be based in the country you grew up in? Is there a good reason to exclude from your portfolio all those overseas-based global companies which buy from and sell to all the same people that the companies based in your home country do?

Emerging markets – too risky?


Emerging markets have a reputation for being one the riskiest areas of the market. Even for those who choose to embrace the idea of international diversification, emerging markets are often excluded (or heavily underweighted) from portfolios. Compared to the perceived safety of developed home markets, it’s understandable why people might choose to avoid them.  

To get an idea of their risk, the chart below shows the drawdowns in emerging markets compared to the S&P 500:

Emerging market drawdownsSource: Larry Swedroe

The chart shows that in most years, the MSCI Emerging Markets Index has a drawdown of a least 10% and a significant number of years of at least 20%. In addition, in most years, the maximum drawdown for emerging markets exceeds that of the S&P 500 (although they usually occur at different times during the year).

This means investors with an allocation to emerging markets must remember it’s extremely volatile and will inevitably experience periods of substantial underperformance compared to the S&P 500.

However, this increased risk has come with higher returns. In the author’s words:

From 1988 (the earliest data we have for emerging markets) through 2017, the S&P 500 earned average annual returns of 12.2% per year, while the MSCI Emerging Markets Index averaged 16.3% per year. In financial jargon, this difference in returns of roughly 4% would be referred to as a “risk premium,” indicating that markets have tended to reward long-term emerging market investors with additional return compared to U.S. equities. This is a sensible result, since emerging market equities clearly possess risks that U.S. equities do not. Emerging market investments could expose an investor to currency risk (the risk that emerging market currencies as a group depreciate relative to the U.S. dollar), heightened geopolitical risk and lower market liquidity when compared to U.S. equities.

So the increased risk of emerging markets is compensated for through higher returns. If we chart these returns by calendar year, we can see that these strong returns have come at different times compared to developed markets:

Emerging market calendar year returnsSource: Larry Swedroe

The differences in when each market provides higher returns shows that emerging market returns aren’t highly correlated to developed market returns. Introducing them into a developed markets portfolio would likely reduce the overall volatility of the portfolio, while also increasing returns.



Having an internationally diversified portfolio means:

  • You’re never exposed to only one country’s sectors. By diversifying internationally, you’re gaining exposure to leading companies all over the world.
  • Similarly, you’re never exposed to one country’s valuations and expected returns.
  • Where a company is listed is becoming irrelevant, so there’s little downside to owning as many companies from as many countries as you can.
  • Emerging markets, while riskier than developed markets, compensate investors for their risk, and provide diversification for a developed market-heavy portfolio.

The next post will look at the counterarguments to the points mentioned in the ‘Against international diversification’ post. Do that facts that cross-country correlations are high and that correlations converge to 1 during a crash mean we shouldn’t diversify internationally?

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