There is a tendency for investors to focus their attention and investment dollars on assets located within the United States. This tendency is well documented and is referred to as Home Country Bias. People are generally more comfortable with the familiar and there is a certain sense of safety that comes with investing in what you recognize. The fact that the U.S. market has performed much better than its international counterpart in recent years further reinforces investor preference for domestic assets. Is this lack of international exposure wise? Or are these investors missing out on a significant opportunity by not allocating (more) internationally?

A strong argument can be made for maintaining a sizable allocation to international stocks. The benefit can generally be boiled down to a reduction in portfolio risk, while maintaining or even improving the expected return.

The reduction in portfolio risk is primarily a function of diversification. The behavior of the various stock markets across the globe will differ based on their own set of circumstances, each with unique growth prospects, fiscal and monetary policies, regulatory framework, and tax structures.  Globalization has increased the tendency for different markets to behave in similar fashion, but they remain far from perfectly correlated. In normal market conditions certain countries will often zig, while others zag.

The chart below demonstrates the impact on portfolio risk of adding international exposure to an all U.S. stock allocation. The X axis represents the portion of the portfolio allocated internationally, and the Y axis reflects the degree of risk reduction(1). As you can see, even a small allocation to non-U.S. stocks has historically reduced portfolio risk. This benefit increases as the allocation expands, with the maximum benefit generally achieved by allocating 25-40% of the stock exposure to non-U.S. companies. Beyond this level the benefit begins to erode as the portfolio becomes overly concentrated in non-U.S. stocks, which are more volatile on a standalone basis.


Risk Reduction From Adding International Stocks to a U.S. Stock Portfolio

Source: Morningstar Direct and DFA. U.S. stocks represented by the Russell 3000 TR index. International stocks represented by the MSCI EAFE NR Index from 1/1979 through 12/1998, and the MSCI ACWI ex US from 1/ 1999 through 1/ 2019. Returns based on monthly data, and the blended portfolios were rebalanced monthly. Risk was represented by standard deviation (annualized).

U.S. stocks have outperformed international stocks for much of the period following the 2008 financial crisis. The scale of the recent outperformance in terms of time and degree can easily lead investors to believe that this is the norm, but is this belief justified? To answer this question, we looked at the relative performance between U.S. and international stocks on a rolling five-year basis going back as far as we have data. The chart below reflects the results of this analysis, and clearly illustrates the relative performance between the two are cyclical. There have been several extended periods over the last 40 years where international stocks handily outperformed the U.S. market.


Cyclicality of U.S. vs. International Stock Returns

Source: Morningstar Direct and DFA. U.S. stocks represented by the Russell 3000 TR index. International stocks represented by the MSCI EAFE NR Index from 1/1979 through 12/1998, and the MSCI ACWI ex US from 1/ 1999 through 1/ 2019. Returns based on monthly data.

If we know international markets have outperformed in the past, do we have reason to believe they could again outperform in the future? The key to this question could lie in the relative valuation between the two.

Valuation is a measure of how cheap or expensive a stock (or entire market) is and is one of the best predictors of return over the long run. It is generally quoted in terms of the price paid for a unit of some fundamental figure, such as earnings. In simple terms: the lower the price you pay for an asset, the better the chance it is going to deliver an attractive return. Finally, relative valuation simply compares how cheap or expensive one investment is relative to another.

The chart below applies the relative valuation technique to the comparison of U.S. vs. international stocks(2). The middle grey bar indicates the level where the two alternatives are equally valued. When the green line is above the top grey line, international stocks are considered expensive. They are considered cheap when the green line is below the bottom grey line. As you can see, international stocks are currently near the cheapest levels relative to U.S. stocks in 18 years (as far back as we have data). This provides a sound basis to expect higher returns from international stocks over U.S. stocks moving forward.


Relative Valuation: U.S. vs. International Stocks

Source: Morningstar Direct. Valuations are based on an equally weighted composite of price/book value, price/earnings, price/sales, and price/cash flow. The chart illustrates the ratio of the international composite over the domestic composite. U.S. stocks were represented by the Russell 3000 index, international stocks were represented by the MSCI EAFE index. Data from 1/2001 to 12/2018. Gaps in the green relative valuation line are due to missing/inconsistent data.

While valuation is arguably the best predictor of long-term returns, it unfortunately does not tell us much about what is going to happen in the coming days, months, or even years. Markets can and will stay out of balance for extended periods of time. A second look at the cyclicality of returns chart, and you can see the outperformance of one market vs. the other is highly variable in terms of both duration and intensity. Like gravity, valuation should ultimately pull the market back toward balance, even if it takes a long time to do so.

Though many U.S. based investors exhibit Home Country Bias, there are compelling reasons to consider and/or maintain a meaningful allocation to international stocks. Through the benefit of diversification, adding international stocks can reduce fluctuations in portfolio value. While investors exhibiting Home Country Bias have been rewarded with strong performance in the U.S. recently, this relative performance has historically been cyclical. The attractive relative value provides us with a reason to expect international stocks to outperform in the future.


  • Risk in this instance is defined as the standard deviation of returns. The reduction in risk is measured by the spread between the standard deviation of the various blended portfolios and the Russell 3000.
  • The Y axis of the relative valuation chart can be interpreted as the discount on buying international stocks vs U.S. stocks. Over the measurement period the price paid for international stocks has average 74% of the price paid for U.S. stocks (based on the equally weighted composites of the four price multiples: P/E, P/B, P/S, P/CF). As of year-end 2018 the price paid for international was 65% of the U.S. price, meaning you can buy international stocks much more cheaply then you have been able to historically.





Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over eight years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
  • BSBA, University of Nebraska, Lincoln, NE


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