International Investing[This originally appeared in the January, 1998 Brinson Monthly Investment Strategy. While that's over a decade ago, the message remains true today. I am grateful for their permission to reprint this article. GWS]
The financial press has lately been questioning the value of investing internationally. They look at the disastrous events recently in southeast Asia and the meager returns in non-U.S. equities in recent years, and the conclusion is that international diversification has been a bust.
What they seem to forget is that diversifying into other markets was never supposed to provide perfect protection to investors from events of this sort. The aim is not to time the markets, trying to be in the best performing market; nor is the purpose of international diversification to guarantee higher returns. Rather it is to offer, over the long run, a better risk-reward tradeoff than investing domestically alone. Combining non-U.S. assets with domestic holdings will always be subject to periods in which the domestic asset performs well and the diversifying foreign assets' performance is subpar. That does not mean that diversifying has failed and that the superiority of domestic assets is assured.
On the contrary, if global capital markets are integrated we should not necessarily expect foreign assets to provide higher returns than domestic assets, unless they have higher systematic risk. What they provide is less than perfect correlation with domestic assets, thus a reduction in the risk of the overall portfolio at the same return level.
Over any given time frame, the risk of any single asset or asset class can be greater than expected and greater than its recent historical experience. Financial commentators are in effect saying that exposing the portfolio to a greater range of assets means that it will necessarily be exposed to some undesirable assets. What they seem to be forgetting in the current environment is that this exposure also means that it will contain the desirable assets as well.
Recalling 1993 is instructive. At that time, emerging equity markets were performing phenomenally well and dollar returns from developed equity markets were also outstanding. Investors confining themselves solely to domestic equities would have had to question the intelligence of their portfolio structure. In the same vein, investors these days have turned 180° and are now questioning the wisdom of placing even a fraction of their portfolios overseas.
In most periods, diversifying a domestic asset class with foreign assets provided lower volatility. This is not true always, as it will not be true always going forward. Likewise, we should not expect foreign assets to consistently provide superior returns to the domestic asset. But, we should expect that, over the long run, these differences in performance between domestic and foreign assets will ensure that the inclusion of non-U.S. assets will lead to portfolios with better risk characteristics for the asset class' given amount of return.
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