The basic principles of diversification say your stock market exposure should be divided between Canada, the United States and the rest of the world.
But that international component can be a portfolio killer. “I invested internationally for a while (at least 10 years) and did terribly,” a reader told me recently. The reason he reached out is that his broker has urged him to diversify a portfolio that is focused mainly on Canada and the United States.
This broker is completely justified in suggesting international exposure. There are great stocks and strong-performing markets in Europe, Asia, Australia and other developed markets – why not have them in your portfolio to complement Canadian and U.S. stocks?
The answer is that long-term returns for international stocks don’t make a strong case for inclusion. Let’s use the MSCI Europe Australasia Far East Index (EAFE) as an international benchmark. EAFE index returns for the 20 years to Dec. 31 were 3.4 per cent on an average annual total return basis. The S&P/TSX composite index delivered annualized total returns of 6.6 per cent and the S&P 500 made 5.6 per cent a year on average (this is a reminder that the S&P 500 had a bad stretch in the 2000s).
The EAFE index has had its moments – it lost 5.6 per cent last year while the S&P/TSX composite lost 8.9 per cent, and its five-year annualized return of 6.2 per cent beats the 4.1 per cent of the S&P/TSX composite index. Comparisons with the S&P 500 are much less flattering. There’s not a commonly measured time frame from one year to 30 years over which the S&P 500 hasn’t beat the EAFE index.
It’s arguable that the S&P 500, with its multinational companies, provides enough exposure to the world outside North America. And yet, international exposure still makes sense. If the U.S. stock market slumps, exposure to Europe, Asian and other regions could help pick up the slack. We saw that in miniature in December, when the S&P 500 plunged 9 per cent, the Canadian market 5.4 per cent and the EAFE index fell 2.2 per cent. EAFE returns have tended to complement Canadian market returns. EAFE outperformed the Canadian market last year, underperformed in the past three years and outperformed over the past five years.
An easy default mix for the stock side of your portfolio is one-third each for Canada, the United States and international markets. If you’re a doubter on international stocks, underweight them. Don’t delete them altogether.