While the historic dominance of the U.S. market makes domestic concentration tempting, global diversification remains the only reliable way to manage long-term risk.
The Illusion of Domestic Superiority
It is easy to look at the last century of financial history and conclude that the U.S. stock market is the only place an investor needs to be. For over 100 years, U.S. stocks have outperformed the rest of the world by roughly two percent per year. This track record, combined with the U.S. market’s massive scale and industry diversity, creates a compelling surface-level argument for foregoing international stocks. Many investors believe that because U.S. companies generate significant revenue abroad, they are already internationally diversified. However, this perspective is flimsy when subjected to rigorous empirical analysis.
The temptation to chase past performance is one of the most documented pitfalls in retail investing. By nature of being diversified, an investor will always hold both the best and worst-performing countries. Looking back at the top performers like the U.S. and imagining the wealth gained by excluding everything else is a form of survivorship bias. We cannot predict which markets will be the future outliers, and relying on historical data to justify concentration often leads to sub-optimal outcomes. In reality, international diversification is critical both theoretically and empirically to sensible portfolio construction.
The Mechanics of the Free Lunch
In 1952, Harry Markowitz transformed financial theory by demonstrating that the risk of a portfolio is not the average risk of its parts, but rather how those parts move together. Diversifying across assets that are not perfectly correlated allows an investor to either increase expected returns without increasing risk, or decrease risk without reducing returns. This is why diversification is famously called the 'only free lunch' in investing. Building on this, the Capital Asset Pricing Model (CAPM) suggests that in an efficient market, the market portfolio—which includes all global assets—is the most mean-variance optimal starting point.
When investors exclude international stocks, they are essentially betting that they can identify a superior subset of the global market. But the data suggests the U.S. outperformance from 1980 to 2020 was largely a function of stocks simply getting more expensive relative to their earnings. When you adjust for these valuation changes, the U.S. outperformance drops from two percent to a mere 0.4 percent per year. High current valuations are actually a hurdle for future returns; when prices are high today, expected future returns are naturally lower. Betting on continued U.S. dominance requires betting that valuations will continue to rise indefinitely, which is a precarious strategy.
Luck, Learning, and Economic Growth
Recent research into whether the United States is a 'lucky survivor' suggests that realized U.S. equity returns have exceeded expectations due to two factors: luck and learning. Luck refers to the fact that many potential disasters for the U.S. economy simply did not materialize over the last century. Learning refers to the process of investors gradually deeming U.S. stocks 'safer' over time, which has driven up valuations. Neither of these factors is guaranteed to repeat. If the past century’s success was fueled by unexpected good fortune, it is a mistake to bake that same level of luck into our future expectations.
Furthermore, there is a common misconception that strong economic growth in a country translates directly to high stock returns. In reality, the relationship is often non-existent or even negative. Expected future economic growth is already baked into today’s stock prices. You cannot earn a riskless profit simply by investing in the most robust economies. Investors in almost every country, with the U.S. being a rare historical outlier, have benefited from looking beyond their own borders. Hoping to be the exception to the rule is rarely a sound long-term investment strategy.
The Persistence of Diversification Benefits
A common critique of international diversification is that it has become less effective as global markets have become more interconnected. While it is true that short-term correlations have increased—meaning markets tend to crash together during crises—this does not negate the benefits for long-term investors. Research shows that while 'discount rate shocks' (how investors price risk) have become globalized, 'cash flow shocks' (the actual performance of companies) remain more localized. For the long-horizon investor, these underlying cash flow differences are what drive wealth creation and destruction.
International diversification acts as a hedge against the 'lost decades' that can plague any single nation. For example, from 1950 through 1989, U.S. stocks actually trailed international stocks by 2.65 percent per year. During the 'lost decade' of 2000 to 2009, U.S. stocks lost over two percent in real terms while international stocks remained positive. Over 10-year rolling periods since 1900, U.S. stocks have only beaten the rest of the world about 59 percent of the time. Diversification protects you from being concentrated in a country that ends up with poor long-term returns, a risk that is more common than many realize.
The Myth of the Multinational Proxy
The argument that one can achieve international exposure by simply holding U.S. multinationals does not hold up under scrutiny. Empirically, the stocks of multinational firms move much more closely with their domestic market index than with the foreign markets where they do business. They are poor tools for diversification because they are still subject to the regulatory, currency, and economic shocks of their home country. Adding actual international equities to a portfolio provides a level of risk reduction that domestic multinationals simply cannot replicate.
Ultimately, the goal of a sensible investor is to minimize the probability of a catastrophic long-term outcome. Data from 38 developed markets since 1890 shows that a domestic-only investor had a 13 percent chance of losing purchasing power over a 30-year horizon. For a globally diversified investor, that risk dropped to just four percent. We cannot know which market will lead the next century, but we do know that broad global diversification remains the most reliable way to navigate an uncertain future. Past success is already priced in; the only way to capture the future is to own the whole world.