The financial media transforms recent history into conventional wisdom with the same facility that Hormel cranks out sausage. 30 years ago only the most financially adventurous strayed abroad— the risks were just too great, and the go-go domestic markets of the 60s provided more than adequate returns. However, by 1986 every financial analyst and his dog was trumpeting the superior returns of foreign equity. No matter that almost all of those gains came from currency appreciation, which was not liable to recur.

We've come full circle. As of year's end, the 5 year return of the S&P 500 was 14.6 percent higher on an annualized basis than for foreign stocks, in large part because of the Japanese financial debacle. Financial pundits now tell us that the practice of international diversification is as dead as John Cleese's parrot. The final nail was driven into its pitiful coffin by none other than Roger Lowenstein in his widely read "Intrinsic Value" column in the Wall Street Journal on December 18, 1997 entitled " '97 Moral: Drop Global-Investing Bunk."

Mind you, Mr. Lowenstein is one of the savviest folks around. Unlike most media gurus, he refuses to be spoonfed mindless pap about market direction from publicity hungry wire house "analysts" and "market strategists." He's one of a handful of financial journalists who have real expertise with number crunching. He does have the odd blind spot, the most obvious of which is his insistence that there is something out there called investment "skill." When the lack of statistical evidence of such among mutual and pension fund managers is pointed out to him, he'll tell you about Buffett (no argument there) and remark about the many hedge fund managers he knows with stellar records. The question is, of course, why aren't there more Buffetts, and why is it that the best anecdotal evidence of investment skill comes from areas with less than transparent performance verifiability.

The gist of his column was that in 1997 a global portfolio was the financial equivalent of an afternoon of root canal work. (And 1998 was much worse than any white knuckle trip I've had in the dental chair.) Further, according to Mr. Lowenstein foreign investing is cetus paribus unsound—in his words, "terra incognita." In other words, US investors should invest in the companies that they know the best:

. . . the burden of proof should be higher away from home. For one, familiarity is an investor's ally. For another, while capitalism is revered in the U.S., it is fragile in may other parts. Disclosure is poor, currencies are risky and the shareholder in New Delhi or even in Amsterdam doesn't have the paramount place in law and in culture that he holds in Kansas City.

The notion that simple familiarity with GM cars or Microsoft software translates into higher returns and lower risks for the domestic investor strains credulity. First and foremost, almost all of the major capital markets of Europe have histories stretching much farther back than the Manhattan buttonwood tree. Second, and more important, the notion that the informational superiority of the US markets somehow enables both small and institutional investors to obtain superior returns is ludicrous on its face. By definition not everyone can earn above average returns, even on the sunny New York Stock Exchange. More importantly, it would seem obvious that it is easiest to earn superior returns in those markets which are least informationally efficient. If your goal is to lead the pack, the most difficult playing field is going to be US large cap stocks. In fact, the evidence that anybody can product sustained above market returns in this arena is marginal at best.

There is in fact no a priori reason to expect that the returns for foreign equity should be any different than for domestic equity. That investors in Sao Paulo, London, or Hong Kong would accept market prices high enough to provide returns lower than in New York in the era of keypad arbitrage is hard to swallow. It turns out that over the 29 years since Morgan Stanley first began to compile the EAFE index of non-US stocks, the return of the EAFE and S&P 500 have been almost identical. I do not believe that this is an accident. Over shorter periods, of course, returns have been very different. I've plotted below the difference in trailing 5 year annualized returns between the S&P 500 and the EAFE (US$). The negative values seen in the first decade of the graph signify higher returns for the EAFE, the positive values in the last decade higher returns for the S&P.



As you can see, over long enough periods the plot seems to dance around the x axis. Is there any guarantee that the future will also demonstrate mean reversion in the foreign-domestic return difference? Of course not, but if I had to place money (and we all do), I'd favor continued long term equivalency of US and foreign stock returns.

A more serious challenge to international diversification comes from scholars who have looked at very long term returns of foreign equity. They find that over the past century only the US and UK have shown high real stock returns (on the order of 5%-7%), but that for the rest of the world real returns were closer to 3-4%. Phillipe Jorion and Will Goetzmann have delved into this area extensively. Their study, Global Stock Markets in the 20th Century is required reading for any diversified investor. Also highly recommended is Brian Taylor's website which provides a wide angle view of global stock and bond returns, to say nothing of the base data for Jorion and Goetzmann's study.

It's difficult to dispute this data. It may be that the assumption of high real stock market returns is simply "history as written by the winners." However, it seems more likely that the reason for generally low long term stock market returns outside the US and UK was that most of the rest of the world was ravaged by two world wars and communism. Ben Graham's special genius was to state clearly in 1934 in Security Analysis that the economic events of the great depression were singular, and not likely to be soon repeated. Similarly, the peculiar military and political history of the 20th Century is not likely to repeat itself either. There is no reason to believe that mankind has eliminated the potential for global conflict. However, the next time Armageddon comes there will be no hiding in the stock markets of the US or UK. The entire planet will have problems dwarfing those on our financial statements, assuming we're lucky enough to get them in the mail.

What if future long term foreign returns are below US returns? Simple mean variance analysis or spreadsheeting shows that not until long term foreign returns are more than 3% lower than domestic returns is foreign diversification detrimental. That's a bet I'm not willing to make.

In 1979, after a punishing 13 year period in US and foreign stock markets which saw stock prices fall in real terms, Business Week published an apocryphal edition with "The Death of Equities" emblazoned on its cover. (For an abbreviated version of this venerable bit of market history, click here.) I suspect that that august publication has learned its lesson; Mr. Lowenstein clearly has not.

copyright (c) 1998, William J. Bernstein