Should you dump your international stocks?

(MoneyWatch) Just a few years ago, during the height of the U.S. financial crisis, I was getting questions from lots of people wondering why they should own any U.S. stocks. Now, with all the financial problems plaguing Europe, many investors want to know if they should run from international stocks. The basic complaint is that they don't see how international stocks would provide additional return or safety in their portfolios. So let's address the concerns now being raised.

Risk and expected return are related

First, the most basic premise of finance is that risk and expected returns are positively related. If an investment is riskier, it should have higher expected returns. Thus, it's not logical that U.S. stocks should be viewed as both safer while providing higher expected returns.

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International stocks have better expected returns

Second, while it now seems that international stocks (at least European ones) are riskier, all one has to do is to check some basic metrics to see whether they have higher or lower expected returns than U.S. stocks. We can do this by using Morningstar's data and checking the metrics of Vanguard's U.S. Total Stock Market Index Fund (VTMSX) and Total International Stock Index Fund (VGTSX). What we find is what we should expect to find: International stocks are priced to provide much higher returns. (Data is as of March 31.)

Generally speaking, the higher the price-to-earning and price-to-book ratios, the lower the expected return. Looking at the P/E ratio, U.S. stock prices are trading almost 25 percent higher than international stocks. And from a P/B perspective, they're more than 50 percent more expensive. These are the largest spreads I can recall, meaning the market sees international stocks as being riskier and having higher expected returns.

Impact on portfolio

Third, the wrong way to consider an investment is to view it in isolation. Instead, you should view how its addition impacts the risk and return of the entire portfolio. The table below presents the evidence for the period 1970-2011. The portfolios are rebalanced annually.

Note that despite international stocks underperforming U.S. stocks, the various combinations of the two produced higher returns than either did in isolation. This is because the returns of the indexes don't move in lockstep and because the portfolios were rebalanced regularly.

Over the long term, returns of U.S. and international stocks have been strikingly similar. This shouldn't come as a surprise. Given the freedom of capital these days to travel almost anywhere among the developed markets in search of the best returns, we should expect to see similar returns. If investors perceived one market to have greater prospects than another, that information would already be incorporated into market prices. The important question is: What, if any, implication does this similarity in returns have for investors making portfolio decisions?

Skeptics argue that if international diversification provided no higher returns, why take the "risk" of diversifying internationally? However, if the question is framed in a different manner, a different answer becomes obvious: "If investing in only the U.S. doesn't get you higher returns, why have all your eggs in one basket?"

Lessons from Japan

For diversification to be effective, you must own assets with non-perfect correlation. The lower the correlation, the better. Low-correlating assets serve to reduce the risk of the portfolio. There may be long stretches when one asset class or region outperforms others. Consider Japanese investors. From 1990-2011, while the S&P 500 returned 8.2 percent a year, Japanese large-cap stocks lost 2.1 percent a year.

However, in 1990, Japan was riding a long winning streak. From 1970 through 1989, Japanese large stocks returned 29.7 percent a year, while the S&P 500 returned 11.6 percent.

Diversification reduces the risk of holding only the losing asset class. It also reduces the risk of only owning an asset class that experiences a financial bubble. The Japanese example demonstrates why I believe that an important determinant of investment success is knowledge of financial history. Such knowledge helps you avoid the noise of the moment, and helps keep you disciplined, adhering to a well-developed plan.

Image courtesy of Flickr user Retinafunk