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International & Emerging Markets Investing

The primary reasons to invest internationally are potentially high returns and diversification. While foreign stocks are typically more volatile than U.S. stocks (for U.S. investors), adding international exposure to a portfolio will normally reduce the risk of the portfolio without lowering expected returns. For instance, a portfolio of 80% U.S. stocks and 20% international stocks will likely have similar yields with less risk than a portfolio of 100% U.S. stocks.

     The negatives of investing internationally often include higher expenses (transactions, management and custody fees), tax issues, and operational issues like disclosure and accounting differences. Additionally, there are added political and currency risks. Investors should also keep in mind that returns from international investing can be heavily influenced by currency movements which can also result in higher volatility. When analyzing past performance, currency effects should be differentiated from local returns. When the dollar is appreciating, returns from foreign investing will be reduced and vice versa (if the currencies are not hedged).

     It is also important to keep in mind that historically, when the U.S. market has dropped sharply, the correlation with foreign markets has tended to go up. In other words, the benefit of diversification is often reduced during sharp downturns. For example in the crash of 1987 and during the Global Financial Crisis, most foreign equity markets also had large drops. There is a Wall Street adage that "when the U.S. stock market sneezes, the rest of the world catches a cold." But over longer periods of time (months and years) the correlations between markets are relatively low and the diversification benefits are substantial.

     There are many options for international investing including buying foreign securities directly (which tends to be less diversified and can be risky), international mutual funds and ETFs (VEA and VWO are good defaults for non-U.S. developed and emerging market stocks), as well as American Depository Receipts (ADRs), which are foreign companies shares trading on US exchanges.

     Investing directly in foreign securities creates a number of dynamics resulting from playing by the rules of the foreign countries. The range of reconciliation between foreign accounting and United States accounting is broad. Foreign companies that list their stock on U.S. exchanges provide full reconciliation to U.S. standards, while most foreign listed companies don't reconcile to U.S. standards. The bottom line is that you can’t always make general conclusions about valuation levels in different countries without a thorough understanding of accounting and other differences between the countries.

     An investing alternative that some in the investment business often mention, is buying securities of American companies with foreign exposure. Most large U.S. companies do business in foreign countries and many own foreign assets. While this does give you some foreign exposure embedded in the security, it is unlikely (although debatable) whether the diversification benefit is as strong as with investing in foreign securities.

     The issue of openness matching refers to the percentage of foreign goods that an investor demands. That is, an individual who purchases 10% of their goods from foreign sources could consider investing in foreign assets accordingly to "match" the future consumption needs. However, this perspective does not take into account the return and diversification benefits of international investing.

     There is an argument that currency markets are inefficient, for multiple reasons. For instance, central banks often trade their currencies to dampen volatility, and corporations often seek to hedge currency exposure for their businesses. That can create arbitrage and value opportunities and the currency markets tend to be very liquid, but most investors should avoid attempting to beat the markets by making large bets on countries or currencies.

Emerging Markets

Emerging markets are typically defined as countries with low per capita gross national product. While developing countries make up over 80% of the world’s population, they have historically accounted for 10% or less of the world stock market capitalization. The benefits of investing in emerging markets include potentially higher returns and greater diversification, while the risks can be greater than investing in developed countries.

     Frontier markets (or pre-emerging countries) are even less developed, but they aren’t as well defined and various data providers (like S&P, MSCI, FTSE, and Russell) have different definitions.

     While emerging markets have become much easier to purchase, thanks to mutual funds and ETFs, concerns are often exaggerated relative to developed markets due to potential political uncertainty, lack of company information, lack of liquidity, trading and custodial difficulties, confidentiality and insider trading problems, as well as even higher transactions costs. However, emerging markets as a group have much lower volatility than the individual markets because of low correlations between the markets. Industries play a larger role in explaining returns of developing markets, while country differences play a larger role in the emerging markets.

     According to Boston-based Pioneering Management Corp., over the 50 years through 1995, emerging market equities showed average annual returns of 16.5% compared with 12.4% for the S&P 500 and 11.8% for the EAFE index (an acronym that stands for Europe, Australasia, and Far East).1 In March 2012, Vanguard noted that since 1985, emerging markets produced an average annual return of 12.2% with a volatility of 24%, versus average annual returns for developed markets over the same period of 9.2% with volatility of 17.3%.2

     It can be tempting to assume that it is easy to identify future strong performing equities in countries based on expected economic growth in the specific countries. In 2005 Jay Ritter documented that over a more than one hundred year period, in sixteen countries there was a "negative correlation between per capita income growth and real equity returns."3 Consumers in competitive economies tend to benefit from higher standards of living in countries with rapid technological change, but investors don't necessarily generate stronger returns. Ritter followed up with a paper published in 2012 in which he confirmed that in both developed and emerging countries "the correlation of countries' inflation-adjusted per capita GDP growth and stock returns is negative" which implies "investors would have been better off investing in countries with lower per capita GDP growth than in countries experiencing the highest growth rates."4 Ritter further argued that there was a positive relationship between dividend growth rates and overall stock returns. Another group of researchers later confirmed in a 2018 paper that "economic growth does not necessarily translate into stock market returns" and that dividends tend to be the main contributor to real returns, while net buybacks of stock are correlated with stock market returns.5

     William Bernstein also summarized the fallacy that fast growing countries and companies should translate into stronger returns in The Investor's Manifesto (2010) where he noted that "China's economy has been growing at a blistering 9 percent real rate per year for more than two decades. Yet between 1993 and 2008 investors actually lost 3.3 percent per year in Chinese stocks, even with dividends reinvested.” Similarly he noted that the Asian tigers--Korea, Singapore, Malaysia, Indonesia, Taiwan, and Thailand-- since 1988 had all had lower returns than the low-growth United States.

     Elroy Dimson, Paul Marsh, and Mike Staunton (DMS) provide even longer term perspective on emerging market returns in their 2019 Credit Suisse Global Investment Returns Yearbook.6 They note that emerging market stocks did outperform developed market stocks from 1950 to 2018. But that was not enough to outweigh severe underperformance in the 1940s (Japan lost 98% from 1945-1949 and investors in China’s market were wiped out when it closed in 1949). The annualized return from 1900-2018 (119 years) in emerging markets was 7.2% compared with 8.2% from developed markets.

Global International Allocation

Some studies have shown that an allocation of more than 50% to international investments can provide improving risk/return benefits, but advisors in the U.S. commonly recommend allocations in the 10% to 30% range. Jack Bogle was interviewed by Morningstar and suggested that investors should carefully consider currency and sovereign risks and limit international exposure to 20% of your portfolio, maybe half in emerging markets and half in developed.7 Yet, Vanguard, the firm he founded recently raised their recommended international allocation to 40% of stock allocations and 30% of bond allocations.8 Fidelity also recently raised their allocation in international funds from 30% to 40%.[9]9

     A 2017 Wall Street Journal article noted that most Robo-Advisors (and probably most U.S. investors) allocate less to international stocks and bonds than their percentage of global markets. At the time, international stocks were 47% of the equity markets (emerging market stocks were 13%), while international bonds were 62% of the global bond market valuations.10

     Rex Sinquefield (Founder of Dimensional Fund Advisors) questioned the benefits of international diversification in a 1996 article titled "Where Are the Gains from International Diversification?"11 Based on empirical evidence (from Fama, French, Sharpe and others) from 1970-94, Sinquefield argued that two risk factors (value and size – discussed further in the following chapters) explain differences in returns in both the U.S. and foreign market. Further he argued that international value and international small stocks diversify U.S. portfolios more than EAFE. Sinquefield therefore concluded that "a sensible reason to diversify internationally is to 'load up' on value stocks and small stocks without concentrating in one geographic region."

     Jeremy Siegel (in Stocks for the Long Run) and others also refer to the work of Elroy Dimson, Paul Marsh, and Mike Staunton, who initially documented the performance of 19 countries over more than 100 years in their book Triumph of the Optimists (originally published in 2002). Dimson, Marsh, and Staunton have been updating their data annually via Credit Suisse, with recent releases expanding the data to 23 countries (via additions of Austria, Portugal, China and Russia).12 Their data is especially useful because it provides a much broader perspective on stocks globally than just looking at the U.S. experience (which arguably is very unique).

     As I mentioned earlier, there are complications and unique circumstances in interpreting international date, for instance DMS point out that all 23 countries have experienced market closures at some point, often during wartimes. They have carefully bridged those closures and constructed a returns history that reflects the experience of investors over the closure periods. However markets in Russia and China were interrupted by revolutions and long periods of communist rule. Their markets were closed with no intention of reopening (1917 in Russia, and 1949 in China), and assets were expropriated, so the assumption is that those that invested in the pre-communist eras suffered complete losses on their capital. That is noteworthy because their data avoids survivorship bias by including the losses.

     The earliest trading of securities dates back to the early 1600 in Amsterdam, and London just before the 18th century. In about 200 years, the U.S. has gone from no equity markets (they didn’t exist before 1772) to valuations representing a majority share of the world’s equity markets. In addition to a stock market that accounts for more than half the value of all stocks worldwide (and many times the next closest, Japan), the U.S. has the largest bond market, the world’s largest economy, and the U.S. dollar serves as the world’s currency reserve. But that raises the question of whether that performance can be sustained and whether the United States itself is an example of cherry picking. Extrapolating that success may mislead investors regarding future equity returns for the U.S. and the world.

     According to DMS, U.S. stocks have averaged about 9½% returns per year before inflation and about 6½% real returns (net of inflation) versus 4½% for a global portfolio excluding the US. The global equity portfolio has returned about 5% more than inflation while the real return for bonds globally has been under 2%.

     U.S. stocks have had very strong performance over more than a century, and have returned significantly more than a global equity portfolio, yet the U.S. was not the strongest among the 23 countries for which DMS have gathered the data. South Africa had even stronger returns (over 7% above inflation). The Australian stock market has achieved an annualized real return of about 6.8% per year since 1900, New Zealand stocks have returned over 6% annually net of inflation and Canada, Finland, the UK, and the Dutch have also had strong long-term equity performance (averaging about 5½% net of inflation). Yet, China has the largest population, but from 1993-2016 equity investors lost money (in addition to the previous total losses when the market closed in 1949).

     Japan is another country with a unique and volatile stock market history. Japanese stocks lost almost all their value after WW2, but from 1949 to 1959, Japan’s “economic miracle” began and equities gave a real return of over 1,500%. Japanese equities remained strong for several decades and by the start of the 1990s, the Japanese equity market was the largest in the world (41% weighting in the world index compared to 30% for the US). But then the bubble burst and from 1990 to the start of 2009, Japan was the worst-performing country among the major markets.

     Determining an appropriate percentage of foreign assets is arguably even more important question for investors outside the U.S. since their respective countries may account for a small percentage of the world portfolio (since I live and work in the United States I have to decline to offer a recommendation for non-U.S. investors).

1. Source: Business Week 9/9/96
2. In Considerations for International Equity
3. Jay Ritter, "Economic Growth and Equity Returns" Pacific-Basin Finance Journal, November 2005
4. Jay Ritter "Is Economic Growth Good for Investors?" Journal of Applied Corporate Finance, Summer 2012
5. Jean-François L’Her, Tarek Masmoudi, and Ram Krishnamoorthy, Net Buybacks and the Seven Dwarfs, Financial Analysts Journal, Fourth Quarter 2018
6. Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse Global Investement Returns Yearbook 2019, February 2019
7. (2010)
10. John Coumarianos, Your Robo Adviser Is More Active Than You Think… September 4, 2017
11. Financial Analysts Journal, January-February 1996
12. Elroy Dimson, Paul Marsh, and Mike Staunton. See (2018) (2017)
Elroy Dimson, Paul Marsh, Mike Staunton, Long-Term Asset Returns (Corrected June 2017)

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Table of Contents and Launch Site

Last update 12/17/2019. Copyright © 2019 Gary Karz. All rights reserved.
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