Stay diversified. 

Research suggests that investors tend to have a "home bias", which typically leaves the bulk (if not all) of their portfolios underexposed to the global stock market and overexposed to idiosyncratic regional risk-which includes both political and economic risks that may be unique to a single country. The current turmoil in the U.S. political system is a timely example.

The Trump administration has sparred with Congress and the federal bureaucracy on a number of policy matters previously unquestioned in Washington's political consensus. This creates uncertainty around outcomes, which is something investors generally do not like. For the year to date through April, the S&P 500 index lost 0.4%, while the MSCI EAFE index (this index tracks large- and mid-capitalization companies of developed markets, excluding the U.S. and Canada) gained 0.7%, and the MSCI Emerging Markets (EM) index gained nearly 1%.

The price movements of the last four months fit a historical pattern for these indexes, which have shown correlations of less than 1.0 over long periods of time. Correlation measures the movement of two assets in relation to each other. A correlation of 0.80, for example, tells us that two assets move together-both up or both down-but at a magnitude that differs.

Diversification of return streams is one of the best reasons to consider investing in foreign stocks. What's more, a case can be made that now is a good time to increase exposure to non-U.S. stocks. While U.S. GDP hasn't grown in any spectacular fashion since the global financial crisis of 2007-2008, its growth has been stronger than most other developed countries and has been fairly consistent. That may be changing.

The International Monetary Fund (IMF) is predicting a modest slowdown in U.S. GDP growth in the coming years, while predicting steady growth in Europe. Japan had experienced stagnant GDP growth for many years, but has begun to show signs of improvement, and emerging markets, which suffered tremendously in 2015's commodity driven selloff, have since regained their footing.

The growth of $10,000.

Source: Morningstar
Source: Morningstar

Investors have largely favored U.S. stocks over both developed and emerging market stocks over the medium term thanks to that relatively robust GDP growth. Over the past decade, the S&P gained 9%, while both the EAFE and the EM index gained a little over 2%, on an annualized basis. The chart above shows the growth of $10,000 invested in each index (unhedged) starting in May 2008 through April 2018. During this period, an investor would have been far better off sticking with a domestic-oriented portfolio.

But the strong run in U.S. stocks has some investors worried that valuations in the U.S. are too rich, especially compared to other major stock markets.

The following chart shows the price-to-earnings ratio (P/E) of the three indexes for the last ten years. The S&P 500's P/E ratio topped 24 in January of 2018 following the passage of tax reform in the U.S., a level not seen since the late 1990s. Following the late-February market correction, the valuation of the S&P 500 dropped fairly dramatically, but remains well above the other two indexes. The contrarian argument points to a concentrated basket of (mostly technology) companies that have largely driven the strong returns in the S&P, and that there are plenty of bargains in U.S. stocks for those willing to do their homework.

P/E ratios.

Source: Morningstar.
Source: Morningstar.

Regardless of which side is ultimately proven right, increasing the geographic diversification of a portfolio can lead to a less volatile return profile. So far in 2018, those fully invested in U.S. have fared worse than those with investments that span geographic regions.

By: Cara Esser

Cara Esser, CFA is a senior investment research analyst and investment committee member in Mesirow Financial's Retirement Planning and Advisory group.

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