Dipping your toe into international waters

Holding foreign equities is a great way to diversify your stock portfolio in the long term.

EMAIL  |   PRINT  |   SHARE  |   RSS
 
google my aol my msn my yahoo! netvibes
Paste this link into your favorite RSS desktop reader
See all CNNMoney.com RSS FEEDS (close)
By Walter Updegrave, Money Magazine senior editor

walter_updegrave__2009b.03.jpg
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)

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"?

Higher returns, lower risk

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.

Taking the plunge

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. To top of page

Send feedback to Money Magazine
Features
They're hiring!These Fortune 100 employers have at least 350 openings each. What are they looking for in a new hire? More
If the Fortune 500 were a country...It would be the world's second-biggest economy. See how big companies' sales stack up against GDP over the past decade. More
Sponsored By:
More Galleries
10 of the most luxurious airline amenity kits When it comes to in-flight pampering, the amenity kits offered by these 10 airlines are the ultimate in luxury More
7 startups that want to improve your mental health From a text therapy platform to apps that push you reminders to breathe, these self-care startups offer help on a daily basis or in times of need. More
5 radical technologies that will change how you get to work From Uber's flying cars to the Hyperloop, these are some of the neatest transportation concepts in the works today. More
Worry about the hackers you don't know 
Crime syndicates and government organizations pose a much greater cyber threat than renegade hacker groups like Anonymous. Play
GE CEO: Bringing jobs back to the U.S. 
Jeff Immelt says the U.S. is a cost competitive market for advanced manufacturing and that GE is bringing jobs back from Mexico. Play
Hamster wheel and wedgie-powered transit 
Red Bull Creation challenges hackers and engineers to invent new modes of transportation. Play

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.