Dipping your toe into international waters

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

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NEW YORK (Money) -- Question: I've always heard you should keep a portion of your stock portfolio in foreign equities. But it seems to me that whatever happens in foreign stock markets also happens in U.S. markets, and vice versa. So do you still recommend investing internationally? --Greg, Charlotte, North Carolina

Answer: I can understand why you question the value of investing in foreign shares. After all, when the Standard & Poor's 500 index lost 37% last year, the MSCI EAFE index, the most widely followed benchmark for international shares, got clobbered too. In fact, it fared even worse than the S&P, losing just over 45%.

So, clearly, any investors who were counting on foreign exposure to prop up their portfolio in the face of imploding domestic stock prices were sorely disappointed.

But the lesson here isn't that diversifying into foreign stocks can't help improve the performance of a domestic stock portfolio. It can. It's just that foreign shares aren't going to provide a safe harbor when the U.S. stock market is falling apart. Indeed, investing pros and academics have known for years that when the U.S. market goes down the tubes, foreign markets go right with it.

So why bother investing "over there"?

One reason is that, as big as the U.S. stock market is, it accounts for only 30% to 40% of global stock values. So if you don't venture beyond U.S. borders, you're excluding a huge number of investment opportunities.

That's not to say that sticking to U.S. stocks will automatically doom you to dangerously subpar performance. An all-U.S. portfolio can do just fine. But when ETFs and mutual funds that specialize in foreign shares are so widely available, I think it's worth a small bit of extra effort to be able to own a piece of the many excellent companies headquartered outside the U.S., not to mention share in the growth of foreign nations big and small.

The main reason to add a dollop of foreign stocks to your portfolio, though, is for the diversification benefit. How, you may ask, can I claim any such a benefit given that U.S. and foreign markets marched off a cliff together last year?

Well, even though U.S. and foreign shares tend to react the same during cataclysms, they don't move in lockstep with each other in more normal times. Investment analysts calculate a statistic known as "correlation" to gauge the extent to which foreign shares zig when U.S. shares zag.

Now, it's possible that globalization is tightening the links between global markets. But most investment pros believe -- as I do -- that the returns of U.S and foreign shares still diverge enough in regular market conditions so that owning both types of stocks rather than just one can give you a portfolio that's less jumpy over long periods.

As a result, investors who add foreign shares to their U.S. stock holdings should be able to earn the same return as an all-domestic portfolio with less volatility. Or, to put it another way, adding foreign shares should allow you to earn higher returns at a given level of risk. And though I certainly don't want to create unrealistic expectations about the advantages of foreign exposure, sometimes it's even possible to achieve diversification's equivalent of Nirvana -- i.e., higher returns with lower risk.

Which brings us to the next question: If you're going to add some foreign shares to your portfolio, how much should you throw in?

That's largely a subjective matter that depends, among other things, on how comfortable you are owning non-U.S. investments and how much effort you're willing to put into managing your portfolio. (After all, the more investments you own, the more you've got to track and the more pieces you'll have to take into account when rebalancing, etc.)

Generally, though, I'd say that investing anywhere from 10% to 20% of your stock holdings in foreign shares is a decent guide, although many advisers put the upper limit at 30%, if not higher. To see how different allocations of foreign stock might affect your portfolio's performance, you can check out Morningstar's Asset Allocator tool. If you're dipping your toe into international investing for the first time, though, I'd recommend starting at the lower end of that range initially. You can always adjust later on.

One caveat, though. People tend to get most excited about international investing when foreign markets are booming. When foreign shares routinely trounced U.S. stocks between 2005 and 2007, for example, U.S. investors were positively ga-ga over foreign ETFs and mutual funds, especially foreign emerging markets funds, which back then were churning out annual gains of 30% or more.

But chasing performance in foreign stocks makes no more sense than it does with domestic shares, and often ends in the same result: investors get burned. That's exactly what happened to people who jumped into emerging market funds at the beginning of 2008 only to see the value of their investment drop by half over the next 12 months.

Bottom line: If you don't own foreign shares, you may want to consider adding some to your portfolio. Just make sure you do it as part of a long-term diversification strategy, not as a short-term gambit to cash in on gains or weather a U.S. market meltdown.