As we officially enter the seventh year of a very, very strong bull market in stocks, it’s only natural for investors to look back and say “if only” — as in, “If only I had invested all my money in [insert the current hot asset class], I would be sitting pretty.”
The “what if” game is potentially hazardous to play as it discourages investors from sticking to a core investment tenet — diversification.
Today the hot asset class is U.S. stocks. Since the end of February 2009, which marked the month-end bottom of the Great Recession’s bear market, Vanguard 500 Index Fund (MUTF:VFINX) has gained 231.9%, or nearly double Vanguard Total International Stock Index Fund‘s (MUTF:VGTSX) 124.2% gain.
Therefore, why, given the strong outperformance of the U.S. stock market and all the negative headlines overseas, would investors even consider investing beyond our shores?
I’ve noticed a new “common wisdom” that diversifying your portfolio to hold foreign stocks is simply a losers’ game. I firmly disagree.
Consider the chart below that shows the difference in performance between U.S. stocks, as measured by the S&P 500, and foreign stocks, as measured by the MSCI EAFE, over the past 31 calendar years. You’ll notice that last year saw the largest divergence between U.S. and foreign stock returns since 1997.
But look for a couple of other things. The largest single year of divergence between U.S. and foreign stocks took place in 1986, when foreign stocks outperformed U.S. stocks by more than 50%. Also, note that foreign stocks outperformed U.S. stocks in all but one year from 2002 through 2009.
U.S. stocks have outperformed in four of the last five years. 2014 saw huge gains in the U.S. market relative to foreign markets not so much because say, Europe’s and Asia’s markets didn’t rise — some did, with Germany up almost 3% and Japan up more than 7% — but because the dollar strengthened against the euro and yen.
I know I am at risk of kicking a dead horse with this story, but diversification, though often met with derision, works in the long run and is one of the building blocks of my approach to investing. At some point, foreign stocks will lead U.S. stocks, and the dollar will weaken against other currencies.
Maybe we are starting to see that already, with the Vanguard Total International Stock Index Fund leading the Vanguard 500 Index Fund 5.7% to 2.5% so far in 2015. Or maybe this is just a two-month blip, and U.S. stocks will regain their leadership role.
Rather than try to guess which scenario plays out, I’d rather stay diversified, knowing that I am positioned to benefit whichever way the story unfolds.
Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, an award-winning monthly advisory letter that keeps subscribers abreast of recent developments at Vanguard, and provides long-term guidance for investing in the Vanguard fund family.
