International Investing: Why Global Diversification Matters

American investors are disproportionately invested in American stocks. This home country bias is understandable: US stocks are the most familiar, US companies dominate financial media coverage, and US markets have significantly outperformed international markets over the past decade. But familiarity and recent performance are not the right basis for portfolio construction, and the concentration risk that results from an exclusively domestic portfolio deserves honest examination.

The global stock market does not move in lockstep. Different countries and regions experience different economic cycles, currency movements, valuation levels, and sector compositions. International diversification provides exposure to these differences, which can reduce portfolio volatility and provide performance when domestic markets are struggling.

This guide makes the case for international investing, explains how international markets differ from the US, addresses the recent underperformance that has made the case harder to make, and provides practical guidance on implementing international exposure.

The Case for International Diversification

The US represents approximately 60 percent of global stock market capitalization but only 4 percent of the world's population and 25 percent of global GDP. Investing exclusively in the US means ignoring 40 percent of the world's investable equity market, including some of the world's largest and most successful companies.

International diversification reduces portfolio concentration risk. All-US portfolios are exposed to US-specific risks: policy changes, regulatory shifts, demographic trends, and economic cycles that affect the US but not necessarily other regions. Adding international exposure spreads these risks across multiple economic environments that do not always move together.

Valuation differences between US and international markets create potential return opportunities over long periods. When international markets trade at lower valuation multiples than US markets, the expected long-term returns from international stocks are mathematically higher, all else equal. The relationship between current valuations and subsequent long-term returns is well-documented in academic research.

Why International Has Underperformed Recently and Why That May Change

International stocks have significantly underperformed US stocks over the 2010 to 2023 period, primarily driven by three factors: the dominance of US technology companies that have no international equivalent in scale, the stronger US economic recovery post-2008, and the dollar's strength relative to other currencies that reduced the dollar-denominated returns of international investments.

Many international diversification advocates have faced years of being wrong. International valuations have been cheaper than US valuations on virtually every metric for most of the past decade, and yet cheap has gotten cheaper. This extended period of underperformance has caused many investors to abandon international holdings, which is precisely the behavior that typically precedes a reversal.

The case for international diversification is not based on the prediction that international stocks will outperform US stocks in any specific period. It is based on the diversification benefit of holding assets that are not perfectly correlated and on the long-run mean reversion tendency of valuations. When US valuations eventually contract or when non-US economies accelerate, international allocation provides participation in those gains.

Developed vs Emerging Markets: An Important Distinction

Developed international markets include Western Europe, Japan, Australia, and other economically advanced countries. These markets have strong institutional frameworks, transparent accounting, liquid markets, and relatively stable political environments. They are diversifying additions to a US portfolio without dramatically different risk characteristics.

Emerging markets include China, India, Brazil, Taiwan, South Korea, and many other developing economies. These markets offer exposure to faster economic growth rates and younger, growing consumer populations. They also carry higher political risk, weaker institutional protections, currency volatility, and less transparent accounting in some cases. Emerging market investments are appropriate as a smaller allocation within the international allocation.

Most total international index funds and ETFs provide exposure to both developed and emerging markets in proportion to their global market capitalization. VXUS, the Vanguard Total International Stock ETF, holds approximately 75 percent in developed markets and 25 percent in emerging markets, which many investors consider an appropriate balance.

How to Implement International Exposure

The simplest implementation is through a total international stock market ETF or index fund. VXUS (Vanguard Total International), IXUS (iShares Core MSCI Total International), and SWISX (Schwab International Index) all provide diversified international exposure at very low cost.

The question of how much to allocate internationally is one of the most debated in personal finance. The global market portfolio suggests roughly 40 percent international and 60 percent US to match global market weights. Many financial advisors recommend 20 to 40 percent international. Most Bogleheads suggest at least 20 to 30 percent. The exact number matters less than having a meaningful allocation.

Currency risk is inherent in international investing because the returns are in foreign currencies that must be converted to dollars. This currency exposure can add volatility but can also be a hedge if the dollar weakens. Currency-hedged international funds eliminate this exposure but add cost and remove a potential diversification benefit. Most investors are better served by unhedged international funds as part of a long-term allocation.

Final Thoughts

The case for international diversification is not that international stocks will outperform US stocks in any given period. It is that a globally diversified portfolio carries less concentrated country-specific risk than an all-US portfolio and provides exposure to a broader range of economic growth opportunities over long investment horizons.

The recent decade of US outperformance has made international diversification harder to advocate and easier to abandon. That is precisely why maintaining it requires the conviction that comes from understanding the underlying logic rather than just following recent performance.

A 20 to 40 percent international allocation implemented through a low-cost total international index fund provides meaningful diversification without requiring active management of multiple country-specific positions. Include it in your portfolio and maintain it through the periods of underperformance that are inevitable in any diversification strategy.