Disneyland has a famous ride, accompanied by an identically named song, called “It’s a Small World (After All),” that was developed to celebrate peace and togetherness. While the ride is intended to remind us of how connected we all are, our beliefs about investing may not be as unified or accepting of differences as the ride and song celebrate.
To be sure, some investors invest in a literal small world. They focus on investing in their local stock market and the companies they know and are familiar with. For U.S. investors, this strategy would have had great results over the past decade, as the U.S. was the best-performing country of all the 23 developed markets that are part of the MSCI World Index. For Portuguese investors, the results would have been disappointing, since Portugal was the worst-performing country over the past decade.
This preference for investing in our local markets is called home bias. And, while the U.S. stock market is one of the largest, the inclination to buy stocks in the country in which we live is well documented across the world. The challenge with this approach is that it ignores the vast amount of investment opportunities that are found outside of our own country.
Consider the following perspectives on the non-U.S. investment opportunity set. At the end of 2018, 46% of the world’s stock market capitalization was outside the U.S., and 90% of listed companies were outside the U.S. Expanding our look beyond stocks, 74% of the world’s economic activity (i.e., gross domestic product) occurs outside of the U.S., and 96% of the global population lives outside of the U.S.
Yet, given the recent strong performance from U.S. stocks, many investors may wonder if we should invest more of our portfolio in the U.S. stock market. We would caution investors to keep the long term in perspective. Markets tend to cycle, and outperformance can occur at different times for different reasons.
We don’t have to look back too far in time to see when U.S. stocks underperformed non-U.S. stocks. Going back only a decade, U.S. stocks, as measured by the MSCI USA Index, lost money for investors in the 2000s, when non-U.S. stocks were up on average. U.S. stocks ranked 20th out of the 23 countries included in the MSCI World Index.
In the graph, we can see how the 2000s, a lost decade for returns, was followed by strong performance in the 2010s. Non-U.S. stocks posted positive results in the 2000s and 2010s, but in the 2010s U.S. stocks were up more. When we combine the returns from the last two decades, we see they average out. While U.S. stocks still outperformed over the past 20 years because of their strong recent performance, diversifying our portfolio into non-U.S. stocks helped lower volatility and deliver a more consistent return.
We feel that there are compelling reasons to invest in the “large world” of investment opportunities. Considering even just these periods, a relatively short time as far as markets go, we know there will be times when U.S. stocks outperform non-U.S. stocks, and we know there will be times when non-U.S. stocks outperform U.S. stocks. What we don’t know is when one will outperform the other. Until we have a crystal ball that can tell us the winning country in advance, we will stick with the sage practice of diversification.