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The Case for Global Diversification
Question: if I told you at beginning of 2014 the US dollar would strengthen by 10% against the other major currencies around the world (the euro, yen, etc...) would that be a good thing?
Well, if you were planning to spend significant time traveling in Europe or Japan, then it might be a good thing as the cost of hotels, restaurants, and services while traveling would be more affordable. But what about your investment portfolio? Would a stronger dollar be good for your investments?
The answer depends on your asset allocation. Many US investors are over-weighted in US stocks. We tend to invest in things that are familiar to us. But is this really the right strategy? Let's look at what happened last year. The S&P 500 price index was up more than 11% last year. If you were only invested in US stocks, you had a pretty good year. But if we look at international stocks, the MSCI EAFE Index (developed international markets like Europe, Japan, and Australia) was down about 4.5% for US investors. But for local investors, the index was up more than 6%. What do I mean by 'local' investor? If you are a Japanese investor investing in your local stock market, you had a good year- up more than 9% in 2014. But a US investor investing in that same market was down 4% last year! Why? The stronger US dollar in the 2nd half of 2014 created a negative currency return for US investors. As the dollar strengthens, our international investments go down in value.
So, if one just made investment decisions based on recent history, then one might be tempted to abandon the concept of global diversification. This would be a big mistake. Take a look at this chart from Callan. Look at the gray box which represents the MSCI EAFE index and in particular find the gray boxes from 2005-2007. Then compare those returns to the returns of the olive green boxes which represent the S&P 500 Index (US stocks). The advantage of the international index over the US index in those three years alone were 8.63%, 10.55%, 5.68%. Much of that advantage was due to a weaker US dollar. You may have also noticed the orange box at the very top of the charts from 2003-2007 which represents Emerging Market stocks. The advantage of investing in this asset class over US stocks in those 5 years were approximately 28%, 15%, 30%, 17%, and 35%. While certainly these stocks did well during that 5 year time period, once again currency had an impact on those positive returns for US investors.
Have we entered a cycle where the US dollar will be strengthening for years to come? The honest answer to this is that nobody knows. (If you see someone on television claim they know, turn the channel!) The best hedge to this uncertainty is to invest small portions of your investments in the various asset classes available to us on a global basis. The US stock market represents 50% of the global stock market. A rational investor should want to participate in the gains available to the entirety of what the capital markets have to offer us. One of the things we need to remember is that there will be some years in which our international investments will be disappoint, but there will also be years when those same investments provide outsized returns compared to our US investments.
So, coming back to our original question which dealt with the stronger dollar. If the dollar strengthens in any given year, our international investments will decline in value on a relative basis. But when the dollar strengthens our international investments will increase in value on a relative basis. Since no one knows whether the dollar will strengthen or weaken in any one year, the best strategy is to stay globally diversified.