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Make money in overseas markets

Foreign stocks can play an important part in a well-balanced investment portfolio. But it's important not to buy into them just because they've seen big gains recently.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: In a world of globalization, should you invest a larger portion of your assets in foreign equities? I'm in my mid-40s and currently have about 40 percent of my money in both international and emerging markets, but I wonder whether I'm taking too much risk. - Hung Lee, Annandale, Virginia

Answer: I'm not sure I agree that globalization should make you more likely to invest in foreign securities or to invest a larger percentage of your assets in them. After all, the more tightly economies around the world are linked, the more you would expect their respective financial markets to move in sync, suggesting you would get less of a diversification benefit from owning foreign shares.

That said, I think we're still a long way away from any "it's a small world after all" scenario where all countries march to the same global economic tune. Besides, by limiting yourself to the U.S.'s shores, you're eliminating some pretty good companies out there - companies it's easy to get a piece of through mutual funds or exchange-traded funds (ETFs) that invest in foreign shares.

All of which is to say that, globalization or no, I believe there's a benefit from investing in foreign shares (most likely through funds or ETFs).

But before I get to the question of how much of your portfolio you might devote to international markets, let's step back a second and think about why someone should consider owning foreign securities at all. Or, better yet, let me start with the wrong reasons to invest in foreign shares.

Over the last couple of years, I believe a lot of U.S. investors have flocked to international stock funds because those funds have generated spectacular returns. Emerging markets funds in particular have averaged gains of more than 50 percent a year for the past three years.

Now, I have nothing against big gains. But I don't like the idea of chasing past performance in foreign stocks any more than I do in domestic investments. That sort of activity can be dangerous, as history shows most people are most likely to jump into booming asset classes after the big gains have been made - not before - and that getting in late can often saddle you with subpar returns or even losses in the years ahead.

I also suspect that many U.S. investors have been looking abroad because they see foreign shares as a sanctuary from the tough market we've been experiencing at home recently. But that reasoning is flawed too, as foreign shares often swoon right along with their U.S. counterparts when the U.S. stock market takes a steep dive.

For example, between mid-July and early August, when the Standard & Poor's 500 index dipped 7 percent, the MSCI EAFE index, a broad benchmark of the shares of foreign developed countries, pretty much marched in lockstep with the S&P 500, dropping 6 percent.

So what is the right reason to invest outside the U.S.? I see foreign stocks as a way to diversify not over short periods, but over the long-term. Such diversifications can in turn potentially enhance your portfolio's gains in the long run while reducing (or at least not increasing) risk.

How, you may ask, is such a win-win possible? Well, it comes down the concept known as correlation, which is a fancy way of saying that over the long-term in normal market conditions, U.S. and foreign stocks don't always zig and zag together.

You can argue about whether globalization is making foreign markets move more in sync with U.S. markets than in the past. But I think most investment advisers would agree that the ties between U.S. and foreign markets are still loose enough, so that adding foreign shares can dampen the volatility of an all-U.S. portfolio and do it without sacrificing returns (and maybe even boost them a bit).

Ah, but what percentage of foreign shares is the right amount? I know of no formal standards for how large a stake one ought to have in foreign shares. But there are some generally accepted ranges. First off, if you're going to go to the trouble of investing abroad, you want to do at least enough to make it worthwhile. So unless you're doing a minimum of, say, 10 percent or so, what's the point?

At the same time, there's a threshold at which the diversification benefit of adding more foreign shares begins to diminish, much the same way that the additional pleasure you get from, say, eating another cookie begins to tail off after you've already downed a few.

Again, there's no official edict for what the upper end of the range might be. But I'd say the consensus among investment advisers is that it's roughly 30 percent or so, although some people, like Jeremy Siegel, the Wharton professor turned market guru, has said he thinks U.S. investors should have upwards of 40 percent of their stock portfolio in foreign stocks.

My position on this is that 20 percent to 30 percent gets you plenty of the benefits of diversification, so somewhere in that range should be OK for most U.S. investors. If you're comfortable pushing the envelope beyond that, fine. But you should be aware going in that, if nothing else, your holdings will be much more vulnerable to currency swings.

Currency trends have worked in favor of U.S. investors recently, since a falling dollar boosts the returns on foreign securities they hold. But, remember, the dollar also rises. And when it does, it will erode the returns on your foreign holdings. I think you've also got to factor a personal subjective component into your decision of how much of your portfolio to devote to foreign stocks.

Many Americans are queasy about owning foreign shares at all, and plenty of others see 20 percent as daring, if not downright dangerous. If you feel that way, then initially at least, perhaps somewhere between 10 percent and 20 percent is about right for you. After all, you don't want to load up with foreign shares and then bail out in a panic if they hit a bad patch just as U.S. shares run into problems.

If you'd like to see how different levels of foreign holdings will affect your portfolio's potential performance, go the RiskGrades site. After registering as a member (which is free), you can set up a portfolio with varying proportions of domestic and foreign shares and then run those portfolios through the site's Return Analysis, which will show you how each portfolio fares on a risk vs. reward standpoint. Keep in mind, though, that this analysis shows what's likely to happen based on historical relationships between different asset classes. It's not a guarantee of future performance.

Whatever percentage of foreign holdings you settle on, remember to rebalance your portfolio once a year or so to bring your domestic-foreign mix back to the level you originally set. If you don't rebalance, foreign shares will become a larger piece of your overall pie when international markets are on a roll and their relative presence will shrink when U.S. stocks are on a tear.

I also want to caution you about foreign emerging market funds. They can be a valuable component to a domestic portfolio for two reasons: They're capable of generating huge returns, and they tend to move more independently of U.S. markets than shares of foreign developed nations, which means they provide a greater diversification benefit.

Their downside is their potential downside. These funds can and do really get hammered from time to time, and history shows they can be particularly vulnerable after they've had a big run-up over several years. So I'd recommend limiting them to maybe 10 percent or so of your foreign stake.

And if you don't own them already, you should be particularly cautious about buying in now. (For more on the risks of these funds, check out this recent column by my Money colleague Jason Zweig.)

One final note: Everything I've said here relates to foreign stock funds. I'm sure advisers can - and some do - make a case for owning foreign as well as domestic bonds. But given bonds' limited return potential I don't think they're worth the trouble.

When it comes to the many things you've got to think about in creating and managing a portfolio, I consider foreign bonds pretty far down on the list. I know that they don't even make my list. But if you want to include them in your portfolio, I'd advise you to limit them to a very small part (10 percent or so) of your overall bond stake.

So now that you've got some issues to think about concerning foreign stocks, I suggest you review your exposure. If you decide you're investing abroad for the right reasons and you're comfortable with your stake, fine. But if you realize that you've jumped into foreign shares out of a false sense of security or because you're hoping they'll duplicate their recent explosive returns, well, paring back might not be a bad idea. Top of page