#$vpl

A reader asks:

Does it make sense to equal weight the Europe and Pacific ETFs as opposed to just buying the entire EAFE index fund? How has this strategy done historically?

This is a great question because so many U.S. investors have a home bias within their portfolio and probably don’t spend enough time thinking about their foreign stock market allocation.

The MSCI EAFE index is generally used as a broad benchmark of the developed foreign stock markets. EAFE stands for Europe, Australia and the Far East. But you can also break out this index by the two largest regions — the MSCI Pacific Index which includes mainly Japan, Singapore, Hong Kong, Australia and New Zealand or the MSCI Europe index which includes places like the UK, Germany, France, Spain, Italy, Sweden and Switzerland.

The historical data for all three of these markets is available going back to 1970 on theMSCI website. Here are the historical annual returns by decade and in total for the EAFE and a 50/50 split between the Pacific and European countries:

The 50/50 allocation showed better overall performance for the entire period and outperformed the EAFE in every decade but one. Volatility was actually lower in the 50/50 allocation as well, but it was a minor difference (22.3% vs. 21.9%). One of the biggest reasons that the 50/50 split outperforms the MSCI EAFE is because of the rebalancing bonus.

These rebalancing benefits are even more pronounced when you combine foreign and U.S. stock markets. Here are the annual returns for the MSCI Europe and Pacific indexes along with the S&P 500:

The interesting takeaway from these numbers is that if you were to take a simple equal-weighted portfolio of all three markets with an annual rebalance, the return jumps to 10.6% — higher than any of the three individual markets on their own.

How is this possible you might ask?

In a word, diversification. The leaders and laggards changed from decade to decade and even year to year. Here are the breakdowns by how often each of the three markets was the top performer each year going back to 1970:

Pacific (40%)

Europe (27%)

United States (33%)

Breaking this down even further, 60% of all annual periods saw all three markets rise at the same time. But all three were only down in the same year 16% of the time. Two markets were down with one in positive territory 11% of the time while two out of the three showed annual gains 13% of the time.

So it does appear that historically there have been benefits to diversifying the international portion of your portfolio more broadly by breaking things up. But there is a catch here. This strategy requires discipline. An investor would have been selling Pacific-based stocks during the 70s and 80s to buy U.S. and European shares which were relatively underperforming. During the 90s that trend reversed and you would have been buying more Pacific stocks and selling U.S. shares when rebalancing. The past few years investors would have been selling the U.S. markets and buying abroad.

It’s not easy for investors to force themselves to adhere to a strict rebalancing plan which is required when implementing a broadly diversified portfolio. It comes down to how many funds you can stand within a portfolio from the perspective of monitoring and ongoing maintenance. For certain investors it’s just easier to keep things simple by investing in a single international fund.

As always, it depends on the investor’s tolerance for complexity and ability to implement a long-term strategy. It doesn’t really matter how you allocate your portfolio within the different asset classes if you don’t have a process in place that allows you to efficiently extract as much performance as you possibly can from each.

Further Reading: Global Diversification: Accepting Good Enough to Avoid Terrible How Diversification Smooths Investment Cycles

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This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

Over the past few years emerging market stocks have been a dead weight in a diversified portfolio. From 2011-2014, the Vanguard Emerging Market ETF (VWO) had a total return of -7.98%. Four years and nothing to show for it.

EM was basically left for dead by investors last year. According to Morningstar, investors pulled $5 billion from EM funds last year, but $2 billion of that was taken out in December alone (h/t James Osborne). The asset class was being shunned by investors because of possible Fed policy moves, high inflation in many EM countries, the threat of rising interest rates and a stronger dollar.

Despite all of these legitimate reasons to stay away from the space, through the first four months of this year VWO is up almost 13%.

A similar dynamic has played out in other foreign markets, as well. Vanguard’s European ETF (VGK) was up a little over 24% in total in the same 2011-2014 time frame. Four months into 2015 it’s already up nearly half that much with close to a 10% gain. Stocks in the Pacific region (VPL) gained a total of just 12% from 2011-2014. They’ve already managed to top that this year alone with a return of more than 15%.

One of my favorite fiction authors is Lee Child who writes the Jack Reacher series. Reacher is an army vet who frequently describes his time in the service as, “Long slow periods of nothing much, with occasional bursts of something.” You could describe financial markets in the same manner.

The chart at the top of the page shows the daily returns on the S&P 500 going all the way back to 1950. You can see the majority of the gains and losses take place in a fairly tight range. Almost 80% of the daily returns were between 1% and -1%. And nearly 99% of all daily moves were within the 3% to -3% range. But there are those clusters of extreme volatility when markets occasionally burst. Most of the huge down days occur in the same periods as the large up days.

These the pockets of volatility were especially pronounced during the bear markets in the mid-1970s, 1987, 2000-2002 and 2007-2009. In fact, over 60% of all daily gains and losses in excess of 3% came during these four bear markets. This is yet another example of how irrational investors can become during times of loss and stress. Everything gets amplified as people try to figure out what to do when they’re losing money.

Pundits have been predicting the return of volatility to the markets for a number of years now, but it really hasn’t happened just yet. Some investors are still nervous because of their experience with the past two market crashes. Maybe the next black swan event is that we won’t have another black swan event for some time? Who knows?

Volatility will make a return eventually.  The markets will constantly surprise investors. The trick is to never be surprised that you’re surprised by what the market does.

Further Reading: Market Earthquakes Emerging Markets Move Fast

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Based on the MSCI World Index, the U.S. stock market makes up over 50% of global equity markets. We constantly hear updates about the Dow Jones, S&P 500 and even Russell 2000, but rarely pay attention to foreign markets.

This home bias causes many investors to overweight U.S. stocks in their portfolio. As everyone debates the current valuation of U.S. stocks, it’s now easier than ever to diversify globally. And while investors worry about the fact that U.S. markets have run so far so fast, many international markets haven’t kept pace.

The S&P 500 (SPY) passed through its 2007 peak in early 2013:

The S&P 600 Index (SLY) of small cap U.S. stocks broke its previous highs in early 2011:

Now for a list of broad foreign markets that are still well below their 2007 peaks seen before the global financial crisis hit.

The MSCI EAFE (EFA):

Emerging Markets (VWO):

European stocks (VGK):

Asian stocks (VPL):

Latin America (ILF):

There’s nothing that says international markets have to immediately outperform U.S. stocks anytime soon. But for those that are worried about CAPE ratios and profit margins, diversifying globally is one of the best forms of risk management over longer time horizons.

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.