Will International Stocks Ever Keep Up with Domestic Stocks?

Key Points:

• While non-U.S. stocks have underperformed compared to U.S. equities in recent years, they still play a crucial role in a diversified portfolio, offering a balance of risk and opportunity that U.S. stocks alone cannot provide.

• Valuation expansion and currency exchange rates are a couple key drivers of the diversion in returns between U.S. and foreign equities during the 2010s. These same elements may reverse course and sustain the relative performance of international stocks.

• Markets are cyclical, and asset classes rotate in and out of favor. Abandoning diversification during a period of underperformance could mean missing out on future gains.  

One of the most common questions I get is whether it's still wise to include non-U.S. stocks in an investment portfolio. After all, U.S. large-cap stocks, particularly large-cap growth stocks, have quite consistently outperformed international stocks for over 15 years. The S&P 500 beat out small-cap stocks, foreign stocks, and bonds. This raises two big questions:

1. Are domestic equities simply superior to international stocks offering better returns with less risk?

2. With U.S. companies having a large global footprint, is there still a need for international stocks?

It's natural to gravitate toward what has performed well recently. But investors should be cautious of recency bias—the tendency to overweight the asset classes that have been winning in the short term. While it may seem counterintuitive, trimming exposure to the high-flying sectors and increasing exposure to underperforming segments (like international equities) can be a smart strategy. Over time, trends shift, and the sectors that are currently overlooked may soon offer significant opportunities.

One reason U.S. stocks have outperformed foreign stocks over the past decade and a half is valuation expansion. Investors increasingly put a higher price tag on domestic stocks relative to their international peers. While relatively higher valuations are quite common for U.S. stocks compared to international stocks, the gap has widened to a level far beyond historical norms. Valuations are rarely a good timing tool, but differences in long-term price/earnings ratios are a major driver of relative returns over five-plus years.

Another factor affecting international stock performance for U.S. investors is currency exchange rates, particularly the strengthening U.S. dollar. Since 2008, the U.S. Dollar Index has steadily risen. As a result, when the dollar strengthens, the value of foreign stocks decreases for U.S. investors who haven't hedged currency risk. A move in the other direction will offer U.S. investors in foreign stocks a tailwind instead of the headwind they have grown accustomed to. If countries like China or Japan, which are large holders of U.S. debt, start selling off U.S. Treasury bonds in favor of other assets or currencies, the dollar could weaken as a result of decreased demand for U.S. debt and the dollar itself.

Adding international stocks to your portfolio might seem risky. After all, international equities tend to be a little more volatile than U.S. stocks. However, their lack of perfect correlation with domestic stocks can actually reduce overall portfolio risk (volatility) when blended. By diversifying internationally, investors can lower their portfolio's overall volatility, making it more resilient in the face of market fluctuations.

Think about this: if stocks always outperformed bonds, no one would buy bonds. Similarly, if bonds always outperformed cash, no one would hold cash. The potential for poor returns in any asset class is both anxiety-inducing and necessary for higher long-term gains. You have to risk it to get the biscuit.  

None of this is to say that investing in a globally diversified portfolio will guarantee better results. It's possible to go all-in on one stock, sector, or region and experience outsized returns—but that doesn't mean it's a wise or prudent strategy for long-term wealth-building. For most investors, global diversification remains a smart and responsible approach. While international equities may have been a drag on investment portfolio returns, they offer the potential for growth and risk reduction. Over the long term, diversifying your portfolio with international exposure can help you build wealth and protect against future uncertainties.

As markets evolve, the merit of out-of-favor asset classes like international stocks will become more apparent. Markets are cyclical, and asset classes rotate in and out of favor. Abandoning diversification during a period of underperformance could mean missing out on future gains. If you're looking to build a balanced, resilient portfolio, don't overlook the value of non-U.S. stocks. For the vast majority of investors, adding international exposure to a portfolio remains a prudent decision that can help build wealth and protect against the uncertainties of the future.