Has International Diversification Lowered Volatility?

One of the most basic questions of investing is what percentage of one’s assets should be invested in
international stocks. Investing in international stocks has two potential advantages, lower volatility and
higher long term returns, but neither is certain and the opposite could occur. Over the next couple posts
we’ll look at both of these potential benefits, attempt to evaluate the risks and develop some heuristics
for making wise asset allocation decisions.

The idea that international diversification has lowered volatility is a central concept of
Modern Portfolio Theory and is well supported by a number of studies. This is because, over the periods
tested, although international markets underperformed the US stock market they tended to zig when the
US zagged and therefore a combination of US and international stocks yielded a higher total return on
investment with lower volatility. However, most of these studies focused on 30 or 40 year periods in the
mid to late 20th century. Recently this trend has weakened significantly. Here are three charts from
portfoliocharts.com showing the return and standard deviation of three portfolios: 100% US Stocks,
100% International Stocks, and a 70/30 mix of both from 1970 to 2019

100% US Stocks

100% International Stocks

70/30 US/International Stocks

  So in the period since 1970 putting 30% of your stocks in the international market would indeed have lowered your volatility, as measured by standard deviation, from 17% to 16.9%, but at the expense of 0.4% in average annual return. Not a bargain worth taking. The chart below from PortfolioVisualizer.com shows returns, standard deviation and max drawdown for the three portfolios from 1986 to 2020.

  Again standard deviation was slightly lower for the diversified portfolio but max drawdown, a more important measure, was greater. In fact international diversification would have increased the max drawdown in the 2002, 2009 and 2020 bear markets. I think we can safely conclude therefore that although international diversification may have lowered volatility in the past, in the most recent past it has actually increased the worst kind of volatility while lowering overall returns. We cannot be certain what the future will hold, but arguing for international diversification to reduce volatility is no longer supported by historical data.

Next week we will examine the potential for higher returns from international diversification.