Betting the farm on foreign funds

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NEW YORK (Money) -- Question: Is now a good time to move more of my portfolio from domestic mutual funds into international funds? - Brett Phillips

Answer: If you're asking whether you should shift more of your money into funds that invest in foreign securities because you believe they'll beat the pants off U.S. funds, then my answer is an emphatic no.

I can understand the attraction of investing abroad. After all, funds that specialize in large foreign growth stocks have gained an annualized 17 percent a year over the past three years, or more than twice as much as the 8 percent annually that U.S. large-cap funds have returned.

Diversified emerging markets funds - that is, those that invest in smaller developing markets in Latin America, Asia and other regions - have done even better, racking up gains of more than 34 percent a year for the past three years.

But moving into foreign funds today in no way assures that you'll experience the same outsize performance in the near future. Indeed, U.S. and foreign stock markets often behave like a seesaw, with one soaring above the other for several years, only to exchange places later on.

And let's not forget that foreign funds recent heady gains have been swept along by the tailwind of currency movements. Over the past five years, the dollar has lost nearly a third of its value vs. the euro. I don't pretend to know the path of the dollar in the years ahead. But I think it would be unrealistic to count on foreign funds getting the same favorable currency boost in the next few years that they received in the recent past.

That said, I think foreign stock funds are an excellent way to diversify an all-U.S.A. portfolio. In fact, adding a dollop of foreign stocks to your domestic holdings can actually enhance the performance of your portfolio, for the simple reason that U.S. and foreign shares don't always move in unison.

I don't want to oversell the effect of this domestic-and-international combo. We're not talking a huge free lunch. And you shouldn't think that foreign funds will be a safe haven when U.S. markets are crumbling. When the U.S. market crashes, foreign markets typically follow, at least for the short term. Over the long-run, however, foreign and U.S. markets zig and zag enough from one another that owning both has the potential to boost your returns a bit without increasing the volatility of your portfolio overall.

The question is how much of your portfolio you should devote to foreign funds to cash in on this effect?

There's no official answer, and you'll find investment advisers recommending that you stash anywhere from 10 percent to 40 percent of your stock holdings in foreign shares. As I've said before, I think 20 percent to 30 percent is a reasonable target for most individual investors, although if you're inexperienced or just wary about having too much in foreign securities, 10 percent to 20 percent can still be worthwhile.

The important thing, though, is that you maintain whatever level you settle on. So, for example, if a run-up in the value of your foreign funds relative to the value of your domestic holdings pushes your foreign stake from your target of 20 percent to, say, 30 percent of your portfolio, then you would want to sell some shares of foreign funds and plow the profits into domestic shares or, barring that, just invest more new money in U.S. funds.

You can do this as part of the rebalancing that you do (or should do) every year to get your portfolio's mix of stock and bond funds back into shape. For more on the benefits of rebalancing and how to do it, click here.

So if you don't own foreign shares but like the idea of making them a part of your core holdings for the diversification benefit they can provide, then I'd say by all means decide on a target percentage and begin moving money into one or more foreign funds. For specific fund suggestions, you can check out our Money 70 list of recommended funds.

But don't invest "over there" on the mistaken idea that you will get outsize gains tomorrow by jumping aboard funds that are riding the top of the performance charts today.