The US stock market experienced a significant downturn in early April following President Donald Trump's announcement of a broad punitive tariffs regime on April 2. While international stocks also suffered, they have generally fared better than their US counterparts. This development has raised questions about the relative strength and safety of US investments compared to those in other countries. As investors grapple with the uncertainty and volatility introduced by these tariffs, the importance of diversification has come into sharp focus.

The Impact of Tariffs on US Stocks

The decline in US stocks was precipitous, with trillions of dollars in market value lost over a matter of days in April. This was an extreme reaction, even though US stocks were considered overvalued heading into 2025. The situation was exacerbated by the decline in the value of the US dollar, traditionally seen as the world's reserve currency. The negative economic effects of the tariffs have led investors to question whether the US remains the strongest and safest investment option.

Amy Arnott, a chartered financial analyst and portfolio strategist at Morningstar, noted that "people are still trying to figure out what’s happening." The global equity team at William Blair observed that "both cyclical and structural changes to US exceptionalism are now on the table, being priced at a greater-than-zero probability of weakening."

The Shift in Market Dynamics

Historically, US stocks have outperformed non-US stocks by as much as four to five percentage points annually over the past decade. However, this trend may be reversing. The Morningstar Global Markets Index ex-US was up 6.46% year-to-date through April 24, while the US Markets Index was down 6.59%. This shift is likely due to two main factors: international stocks being less expensive than their US counterparts and heightened uncertainty about US policies.

Vanguard's investment outlook forecasts that international equities will outperform US stocks over the next several years due to more attractive valuations. Despite this, net money flows into US equity mutual funds and ETFs have remained positive year-to-date through mid-April, suggesting that US equities are still seen as an attractive bet overall.

The Case for Diversification

The recent market volatility has underscored the importance of diversification. A balanced portfolio with 60% stocks and 40% bonds typically offers a lower risk and volatility profile than portfolios heavily invested in stocks. For example, a portfolio invested solely in US stocks was down roughly 3% year-to-date, while a portfolio with 20% of its stock portion in international equities was down just 0.41%. "If you had international exposure, you would have done significantly better," Arnott said.

US Treasuries, traditionally a safe haven during stock market downturns, have also experienced volatility. Normally, investors flock to US government bonds when stocks plunge, driving up prices and lowering yields. However, in mid-April, there was a sell-off, pushing Treasury yields higher. This unusual behavior raises questions about the future stability of US bonds.

The Role of Target Date Funds

For investors with retirement accounts, target date funds offer built-in diversification. These funds have historically been overweight in international stocks, allocating 30% to non-US assets compared to the typical 25% in equity mutual and exchange-traded funds. This diversification has started to pay off this year, according to Jason Kephart, a senior principal of multi-asset strategy ratings at Morningstar. "Diversification is finally being rewarded," he said.

Strategic Asset Allocation

For investors managing their own asset allocation, Arnott suggests having up to 35% of the stock portion of their portfolio in non-US equities, mirroring the weighting of the MSCI All Countries World Index (ACWI). Alternatively, investors can follow the advice of Adam Grossman, a chartered financial analyst and founder of Mayport Wealth Management, who recommends an allocation to international stocks "in the neighborhood" of 20%. This level provides diversification benefits without introducing significant currency risk.

Investors can gain exposure to non-US stocks through low-cost world markets ex-US index funds. For bonds, Arnott recommends a core bond fund for 401(k) investments, which will be diversified across different types of government and investment-grade corporate bonds. For individual bond investments, she advises focusing on the short- to intermediate-term portion of the yield curve and being cautious with long-term Treasuries, where the risk is greatest.

The recent market volatility and the decline in US stocks highlight the importance of diversification in investment portfolios. While US stocks have historically outperformed international stocks, the current economic climate and policy uncertainties suggest that this trend may be changing. Investors should consider allocating a portion of their portfolios to international equities to benefit from more attractive valuations and to hedge against the risks associated with US market volatility.

The future of the US economy and its position as a global investment leader remains uncertain, particularly in light of ongoing trade tensions and policy changes. As investors navigate these challenges, diversification remains a key strategy for managing risk and maximizing returns. Whether through target date funds or individual asset allocation, the case for including international equities in investment portfolios has never been stronger.