I have never been to Japan and can’t claim any special knowledge of the country—and yet lately it’s been much on my mind. Japan is today’s poster child not only for wretched long-run stock market performance, but also for what happens to economic growth when the workforce contracts. Still, Japan’s troubles make me an even bigger advocate of investing abroad. Below, I explain why.
In late 2008 and early 2009, I read and heard many dire comments about the stock market. But I don’t recall anyone saying, “Stocks will never return to their 2007 peak.”
Today, U.S. shares are overvalued based on numerous market yardsticks. Yet I strongly doubt stocks will ever fall back to their March 2009 market low, and probably only those on the financial lunatic fringe would disagree.
What’s my point? Because stocks are so richly valued, a sharp short-term market drop wouldn’t be a big surprise—and modest long-run returns are probably in the cards. But I’m not about to become a market timer and bail out of stocks. Think of it this way: Deciding whether to stay in the market or get out is an asymmetrical bet. If the global stock market goes down, it should eventually recover. But if the global market goes up, there’s no certainty that it will ever revert to earlier levels.
Seem reasonable? Before you buy my argument, consider an inconvenient example: Japan. The Tokyo market doesn’t show signs of returning to its 1989 peak any time soon. But I don’t consider that evidence in favor of market-timing or active stock selection. Rather, I consider it an argument for global diversification. Why? Read on.
The more you have in stocks, the more you should allocate to foreign stocks. What’s my rationale? For many years, I’ve wrestled with the question of how much to invest abroad.
There’s no clear consensus among experts. Some folks take their cues from the relative stock market value of U.S. and foreign shares. If that’s your guide, you would put roughly half your money in U.S. stocks and half abroad.
Others start with a 100% U.S. stock portfolio and then add foreign shares in an effort to reduce volatility. You can get much of this risk reduction by moving 20% of a U.S. stock portfolio into foreign stocks, but you can notch incremental risk reduction by stashing as much as 40% abroad.
Yet others focus on matching assets (i.e. your portfolio) with liabilities (i.e. how you’ll spend the money). U.S. retirees will spend much of their savings on U.S. goods and services. Thus, even if you’re invested heavily in foreign stocks when you are in your 20s and 30s, you should probably lower that allocation as you approach retirement, knowing you’ll soon be tapping your portfolio for income and, at that juncture, you don’t want to be taking too much currency risk. As you throttle back your foreign exposure, factor in your bond holdings. If you’re increasing your allocation to bonds as you approach retirement and those bonds are largely or entirely denominated in dollars, you might find you have decreased your currency exposure enough, even if you don’t change your mix of U.S. and foreign shares.
The above considerations are driven mostly by worries about risk, measured either by volatility or currency exposure. But I think there’s another aspect of risk that we need to consider—and it hit home as I thought about the performance of Japanese stocks over the past 26 years. Today, the Nikkei 225 index languishes at less than half its 1989 peak.
You can think of the global financial markets as comprised of four key sectors, all roughly equal in size: U.S. stocks, U.S. bonds, foreign stocks and foreign bonds. Now, imagine that you are 100% in stocks. Some would argue that’s entirely reasonable if you’re in your 20s or 30s, with many decades of paychecks ahead of you and no need to dip into your portfolio for income.
If that 100% stock allocation consists entirely of U.S. stocks, you are betting on just one of the global financial markets’ four major sectors. What if the U.S. turns out to be the next Japan? It strikes me as improbable. But in the late 1980s, when Japan’s economy was the envy of the world, the subsequent bear market would also have been considered wildly improbable.
My contention: If you’re going to invest heavily in stocks, you should consider allocating as much as 40% to foreign shares, so you aren’t betting too heavily on a single country’s stock market. I don’t know whether that will help or hurt returns. But it will reduce risk—and potentially save you from financial disaster.
What if you have, say, half your portfolio in bonds? I would still favor owning a globally diversified stock portfolio. But investing substantial sums abroad is less imperative, because—thanks to the bonds—your financial future is no longer so heavily dependent on a single country’s stock market.
Which foreign stock funds should you buy? As usual, all my favorite funds begin with V. I personally own a mix of Vanguard Developed Markets Index Fund, Vanguard Emerging Markets Stock Index Fund and Vanguard FTSE All-World ex-U.S. Small-Cap Index Fund. I also have a stake in Vanguard Global ex-U.S. Real Estate Index Fund, and I recently added Vanguard International High Dividend Yield Index Fund to give my portfolio a modest value tilt. To be sure, this is a lot of funds—and most folks would probably fare just fine with a total international stock fund, such as Vanguard FTSE All-World ex-U.S. Index Fund.
In earlier newsletters, I have mentioned that the U.S. economy’s growth rate has slowed sharply over the past 15 years and will continue to slow, as the population ages and the workforce expands less quickly. This, of course, is true across the developed world. Consider some figures from the IMF. Over the past eight years, which—admittedly—includes the Great Recession, the developed world has grown at just 0.9% a year, versus 2.8% for the previous 10 years.
But it’s a different story in emerging markets, where growth over the past eight years has notched a heady 5.2% a year, barely slower than the 5.8% annual rate for the previous decade. Overall, the global economy has expanded 3.2% a year over the past eight years, versus a 4.2% annual rate for the prior 10 years—but the bulk of the blame lies with developed economies and their aging populations.
True, many emerging market economies are currently struggling. But those struggles don’t yet reflect the almost unalterable demographic headwinds that confront the developed world. The upshot: For investors, emerging market stocks remain a more promising long-term bet—and the recent poor market performance makes them even more attractive.