(MONEY Magazine) – SPOOKED BY THE TURMOIL IN INTERNATIONAL stock markets, Americans are increasingly reluctant to invest abroad. In the first two months of 1995, only $829 million of fresh cash flowed into funds that buy foreign stocks--about 10% of 1994's monthly average. Big mistake. "Investors should always hold foreign funds," says Richard Holbrook, director of global equities at San Francisco investment firm Bailard Biehl & Kaiser, "because international shares tend to outperform U.S. stocks by about three percentage points a year over the long term."

As the chart on page 30 shows, in the 10 years to April 1, Morgan Stanley Capital International's index of major European, Asian and Australian stock markets gained 17% annually, vs. 14.4% for Standard & Poor's 500-stock index. And despite the equity markets' recent meltdown in less developed countries such as Mexico, where shares plunged a staggering 53% after the peso's December devaluation, International Finance Corp.'s index of 26 emerging stock markets rose 17.5% annually over the decade.

What's more, investment advisers contend that foreign markets will continue to offer the best opportunities for growth. For example, Vivian Lewis, editor of the monthly newsletter Global Investing ($97 a year; 508-457-5222), forecasts gains of 13% to 20% over the next 12 to 18 months in shares of European manufacturers, such as paper and steel producers, whose earnings will surge as France, Italy and other continental countries climb out of recession. To grab similar gains over the next five to 10 years, pros like Leila Heckman, managing director of international investing at Smith Barney, suggests funds that zero in on the emerging markets in Africa, Asia and Latin America, where many economies are expected to grow twice as fast as those in industrialized nations.

Superior returns aside, there's another, seemingly paradoxical reason to invest overseas--safety. Since prices of foreign shares don't usually rise and fall in synch with U.S. stocks, you can significantly reduce your portfolio's overall risk by diversifying into international funds. Let's say, for example, that in 1985 you put 70% of your money in U.S. stocks and split the remainder evenly between shares traded on emerging and fully developed foreign markets. By last April 1, you would have gained 15.9% annually, vs. 14.4% for an all-U.S. portfolio--and you would have taken nearly 10% less risk.

The message for stay-at-home investors: Start moving 20% to 30% of your stock portfolio into international funds. Below we describe the best buys in the three broadest categories of foreign funds. In order of least to most risky, they are diversified international funds, which divide their assets among a broad range of regions and countries; diversified emerging markets funds, which spread their holdings among less developed nations, and regional emerging markets funds, which specialize in rapidly growing economies in a particular area, such as Asia or Latin America. Generally, unless temporary price dips of 20% or more won't upset you, stick to the most widely diversified funds. If you do venture into riskier regional emerging markets funds, advisers generally suggest limiting them to about 10% of your equity holdings. For performance data as well as the risk levels on all funds mentioned in this story, see the listings that begin on page 62. (Not all of the funds recommended below appear in "80 Terrific Funds to Buy Now" on page 44, since that story emphasizes broadly diversified portfolios and includes global funds, which can invest in the U.S. as well as abroad.)

DIVERSIFIED INTERNATIONAL FUNDS. By spreading their money among a wide number of markets, these funds sharply reduce your chances of being hammered if one or two fall apart. Even so, you should expect occasional years in which most foreign funds get pounded--as happened in 1994. In the 12 months to April 1, for example, the average international fund lost 4%.

Amy Arnott, associate editor of the biweekly advisory service Morningstar Mutual Funds ($395 a year; 800-876-5005), recommends $5.5 billion T. Rowe Price International Stock (no load; 800-638-5660), which holds stocks from 28 countries, and $5.7 billion Templeton Foreign (5.75% load; 800-292-9293), which divvies up its holdings among 37 nations. Banking on Europe's economic recovery, T. Rowe Price's investment team, led by Martin Wade, 52, has put more than 50% of the fund's assets into European countries such as the United Kingdom, France and the Netherlands. Wade has also sunk about 15% of the fund's money into Pacific Rim emerging markets, including Malaysia and Singapore, where he's finding shares that are cheaply priced relative to their strong earnings potential. Templeton Foreign manager Mark Holowesko, 35, meanwhile, is looking to increase the 21% or so he has already invested in emerging markets such as Argentina and Mexico to take advantage of the rebound he expects from last year's disappointing returns.

Ken Gregory, editor of the monthly newsletter No-Load Fund Analyst ($195 a year; 800-776-9555), favors $1.5 billion Warburg Pincus International Equity (no load; 800-257-5614). Warburg Pincus manager Richard King, 50, has invested just over half of his fund's assets in Europe and Japan, while sprinkling the rest among 12 emerging markets around the globe. (For more on this fund, see "Five Great Undervalued Stock Funds" on page 14.) San Francisco money manager Earl Osborn of Bingham Osborn & Scarborough likes $2.7 billion Vanguard International Growth (no load; 800-662-7447), in part because the fund holds annual expenses, which can easily eat up 1.5% to 2% of an international equity portfolio's return, to a razor-thin 0.47%. Vanguard manager Richard Foulkes, 49, keeps two-thirds of his portfolio in growth stocks, mostly in developed nations in Asia and Europe. But he is now looking to raise his recent 17% stake in fast-growing countries such as Indonesia, Malaysia and Singapore, because he believes they are "doing everything right to move from poverty to economic health."

You can shoot for higher international returns by adding a fund that specializes in the shares of small and mid-size companies. Ken Gregory suggests $379 million T. Rowe Price International Discovery (no load; 800-638-5660) and $657 million Tweedy Browne Global Value (no load; 800-432-4789). The Discovery management team's emphasis on small companies with median market capitalizations of $500 million, plus its 44% stake in emerging markets, has made the fund almost 20% more volatile than larger-cappers over the past five years. But Gregory believes the extra risk is worth taking because the fund offers shareholders a way to capitalize on the superior gains of fast-growing small-cap international stocks. Tweedy Browne's quartet of managers specialize in the issues of medium-size companies with $1.3 billion median market capitalizations that sell at a discount to book value or have below-market price/earnings ratios. The fund, which shies away from most emerging markets, recently concentrated most of its assets in developed countries, ranging from France, the Netherlands and Switzerland and in Europe to Hong Kong and Japan in the Far East.

DIVERSIFIED EMERGING MARKETS FUNDS. If you already own one or two diversified international funds, you might consider investing 10% or so of your equity holdings in funds that invest in a broad range of emerging markets. Keep in mind, though, that these stocks can zoom to staggering gains one year--and suffer bloodcurdling losses the next. For example, Turkish stocks rose 208% in 1993 but fell 53% the following year. So hop aboard only if you can commit your money for five years--and you would feel comfortable weathering temporary setbacks that could make the 1987 U.S. crash seem like a ripple in a placid pond.

Sheldon Jacobs, editor of the monthly No-Load Fund Investor ($119 a year; 914-693-7420), recommends $791 million Montgomery Emerging Markets (no load; 800-572-3863), whose co-managers Bryan Sudweeks, 40, and Josephine Jimenez, 40, have proved themselves adept at bailing out of markets just before they tumble. By paring their Mexican stockholdings by half to 6% before last year's mid-December devaluation of the peso, for example, the managers held the fund's 1994 loss to 7.7%, vs. 14.5% for its peers. Jimenez and Sudweeks have divided their assets among 31 emerging markets. Their biggest positions are in Malaysia (15%), Brazil (9%) and Taiwan (8%), which Sudweeks says "are led by reform-minded governments and have vibrant economies and corporate sectors."

Morningstar emerging markets analyst Eileen Makoff favors $1.9 billion Templeton Developing Markets (5.75% load; 800-292-9293), run by 20-year veteran Mark Mobius, 58. A value investor who waits for bargains, Mobius currently has roughly 32% of his assets temporarily in cash, biding his time until he's ready to move into such untested markets as Nigeria and Russia. He's invested the remaining 68% in a broad range of emerging markets, with the largest portions in Hong Kong (17%), Brazil (7%) and Turkey (5%). "These countries are working on their problems," says Mobius. "and we think there are good opportunities there."

REGIONAL EMERGING MARKETS FUNDS. You can earn the loftiest long-term returns-if you're willing to assume equally high risks-by buying one or two funds that invest solely in a promising region's emerging markets. Most analysts caution against jumping into Latin American funds at this point. Reason: Foreign investors will continue to keep their money out of the region until Mexico clearly gets its economic problems under control. Instead, money manager Earl Osborn suggests that you home in on Asia's battered markets, the only emerging markets he thinks will produce returns over the next year or so that are high enough to compensate you for the risk of investing in them.

Osborn favors $1.8 billion T. Rowe Price New Asia (no load; 800-225-2470) and $377 million Scudder Pacific Opportunities (no load; 800-225-2470). New Asia team leader Martin Wade has concentrated most of the fund's money in Malaysia (22%) and Hong Kong (21%), although he has recently been eyeing Korea (now 5% of assets) because he believes the country's profit potential in exports is especially bright now that the strong yen has jacked up the price of Japanese products. Scudder Pacific Opportunities, managed since last year by Elizabeth Allan, 41, also holds large stakes in Hong Kong (17%) and Malaysia (13%), but she is branching out into smaller fast-growing Asian markets, such as India (8%) and Indonesia (6%).

"Emerging markets will definitely be more volatile than U.S. exchanges," says Philip Young, a money manager who specializes in emerging markets at the investment firm Strata Portfolios in Santa Rosa, Calif. "But if you hang in for five to 10 years, you can grab annualized returns of 15% to 20%."

Reporter associate: JEANHEE KIM