Do You Really Need to Invest in Foreign Stocks? | Wealthfront (2024)

US stocks are popular with investors, and it’s easy to understand why. As an asset class, US stocks have recently had several strong years, and they tend to dominate market news and headlines. They also comprise about 60% of the global equity market. To be sure, US stocks are important for investors—in Wealthfront’s Classic portfolio, they currently make up anywhere from 25% to 59% of our recommended allocation, depending on your risk score. But we also think foreign stocks warrant consideration and inclusion in your portfolio in order to achieve global diversification.

If you’re a US-based investor, it can be tempting to invest only in US stocks because they are more familiar, and this temptation is so common it has a name: home country bias. But that doesn’t mean it’s a good idea. In this post, we’ll look at historical data to help inform your thinking and make the case for investing at least some of your portfolio in foreign stocks. We’ll use “foreign stocks” as shorthand to describe both foreign developed stocks (which we define as an ownership share in companies headquartered in developed economies like Switzerland, Germany, the UK, Australia, and Japan) as well as emerging market stocks (which we define as an ownership share in companies headquartered in developing economies like Brazil, India, South Africa, and Taiwan). Here’s what you need to know.

US stocks don’t always outperform foreign stocks

Some investors might skip buying foreign stocks because they believe, incorrectly, that US stocks always perform better than both foreign developed stocks and emerging market stocks. But history tells us that this simply isn’t the case. In fact, according to a 2023 analysis by BlackRock, international stocks have performed better than US stocks in over 40% of 10-year rolling periods between March 1986 and December 2022.

Motley Fool reports that between 2000 and 2010, emerging market stocks had an annualized pre-tax return of 18.5%, while US stocks returned just 4.1%. This might sound like a fluke, but it’s actually expected given emerging markets stocks’ higher volatility—more risk generally means higher expected returns. Accordingly, as we write in our investment methodology white paper, emerging market stocks have a higher net-of-fee, pre-tax expected return than US stocks.

Foreign developed stocks have outperformed US stocks in recent memory, too. We analyzed the performance of the ETFs used to represent each asset class in Wealthfront’s Classic portfolios as far back as 2010, and found that the ETF we use for foreign developed stocks outperformed the ETF we use for US stocks in 2 out of the last 14 years. This is despite the fact that the US stock market is considered to have been in a bull market for the vast majority of that time.

We hope this information serves as a powerful reminder that in the grand scheme of things, it is very difficult to predict which asset classes will perform better than others in the short term. US stocks don’t always come out on top, and it’s not possible to know ahead of time which country’s stocks will. Attempting to predict periods where US stocks or foreign stocks or any asset class will outperform is just another form of market timing. And unfortunately, market timing doesn’t really work. Instead, we encourage investors to consider owning stocks from a variety of countries so you increase your odds of having the winners in your portfolio over time.

Foreign stocks are cheaper than US stocks right now

Another reason to invest in foreign stocks is because they are relatively cheap at the moment. US stocks are more expensive than their foreign-market counterparts based on their price-to-earnings (PE) ratios, a common way to value stocks and indices by comparing their prices relative to their earnings. In simple terms, when a stock or index has a high PE ratio, this means you are paying more for each dollar of earnings. Note that when calculating PE ratios for indices, it’s typical to exclude negative earnings, as they skew the ratio and make the results less meaningful. The usual approach is to divide aggregate price by aggregate earnings and exclude negative earnings from that calculation.

As of December 31, 2023, the PE ratio for the Vanguard total US stock market ETF VTI was 22.9, compared to 13.3 for Vanguard FTSE Developed Markets ETF VEA, and 7.8 for the Vanguard Emerging Markets Stock Index Fund VWO. (These are the three primary ETFs we use for US stocks, foreign developed stocks, and emerging market stocks in Wealthfront Classic portfolios.) The chart below plots the PE ratios of these three ETFs since 2007. As you can see, VTI has the highest PE ratio, often by a significant margin, for most of that time period, with the gap widening over time.

As the chart above shows, foreign stocks are a relative bargain compared to US stocks at the moment.

We can compare the relative cost of foreign versus US stocks over a longer period of time by looking at the CAPE (cyclically adjusted PE) ratios for two indices: the MSCI World ex US (which contains large-cap and mid-cap stocks from developed market countries excluding the US) and the S&P 500. CAPE ratios differ from PE ratios in that they incorporate 10 years of earnings data, and are less impacted by economic cycles as a result. As you can see in the chart below, it isn’t always the case that US stocks are relatively more expensive than foreign stocks, but it has been true for the last roughly 15 years.

We don’t think you should necessarily pick and choose which geographies to invest in based on their PE or CAPE ratios, because that’s a form of market timing. That said, it is helpful to be aware of the broader historical context. In short, different regions have historically taken turns being cheaper and more expensive over the years, and history suggests they may revert to the mean over time. Investing in foreign stocks, then, is simply a way of balancing out your portfolio for the long run.

Diversification matters

Investing, by definition, involves uncertainty and risk, but are a few things investors can control. Diversification is one of them. Diversification is the practice of buying a variety of different investments with the goal of balancing risk and reward in your portfolio. A well diversified portfolio can help you maximize your expected returns without taking on unnecessary risk. And buying foreign stocks in addition to US stocks is one way to diversify your portfolio.

Even if you invest during a period where US stocks outperform foreign stocks, having both in your portfolio can help dampen the effects of volatility. For instance, if US stocks are broadly and negatively affected by a high inflation reading one day, it’s possible foreign stocks will not be similarly impacted. In that situation, if you only owned US stocks, the ensuing volatility could make you nervous and prompt you to sell your investments and potentially miss the recovery. However, if your portfolio also contained foreign stocks (or other investments that aren’t highly correlated with US stocks), you might be in a better position to ride out the volatility and stay in the market or, in the event you were planning to sell investments, have a less sharp downturn in your portfolio.

Key takeaways

Before you decide to forego foreign stocks in favor of only buying US stocks, here are a few things you should keep in mind:

• US stocks have had a strong few years, but they don’t always outperform foreign stocks.
• Foreign stocks are currently less expensive than US stocks on a relative basis. You’ll pay less for each dollar of earnings from foreign stocks.
• Diversification matters, and including foreign stocks in your portfolio could improve your risk-adjusted returns.

Ultimately, we believe US stocks and foreign stocks have a place in a well diversified portfolio. If you’re not sure how to navigate building a portfolio that’s diversified across asset classes and personalized to your risk tolerance, we suggest investing in one of Wealthfront’s recommended portfolios: We offer a Classic portfolio, Socially Responsible portfolio, and Direct Indexing portfolio. (It probably goes without saying that all of them contain both US stocks and foreign stocks.)

Subscribe to our blog