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Does Including International Stocks Really Make You More Diversified?

A reader writes in, asking:

“I’ve read that Mr. Bogle doesn’t think investors should use an international allocation. His argument makes sense to me. With our globalized economy, it seems that the performance of companies here in the United States would be dependent on what is going on in other countries anyway, allowing for international diversification without an international fund. What do you think?”

This is one topic where, despite my immense respect for Jack Bogle, I do not agree with his position. I strongly prefer to have international stocks in my portfolio.

My line of thinking is perhaps best explained with an analogy.

Imagine that your current portfolio consists solely of four different stocks. Now imagine that you have the option to add a fifth stock to the portfolio. Would you do it?

How would your answer change if you found that, historically, that fifth stock is so closely correlated to the other four stocks that, based on historical backtests, adding that fifth stock does literally nothing to improve the volatility or returns of the portfolio? Would you still add the fifth stock to the portfolio?

For me, the answer would be an emphatic “yes.” By adding a fifth stock, I’m less dependent on the performance of the other four stocks. And while the stocks have historically been highly correlated, that could change at any time. One of the stocks could experience a significant decline that is specific to that one business, while the other stocks continue to perform just fine. And in such a case, I would be very happy to have more stocks in the portfolio so that my losses are minimized.

In other words, I would be eager to add additional stocks to the portfolio, even if a historical backtest showed that doing so offered little benefit.

For me, a similar line of thinking applies when considering whether to hold international stocks or not. That is, my desire to hold them isn’t based on historical backtests. (That said, historical tests do suggest that an international allocation provides a modest improvement.) And my desire to hold international stocks is not diminished by the fact that the U.S. stock market and developed markets abroad tend to be fairly highly correlated. I own international stocks primarily because I’m concerned about a scenario in which, due to some unforeseen event, that high correlation breaks down and the U.S. market performs significantly worse than other markets.

In short, I would argue that you are more diversified with more stocks (or more industries, or more countries) in your portfolio, even if that doesn’t show up in the form of dramatically improved back-tested results.

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