A retirement portfolio of global proportions

(Money Magazine) -- Question: What is the difference between a total world index fund and a total international index fund? How you see such funds as part of a retirement portfolio? --Dave, Apple Valley, Minnesota

Answer: There's a big difference between a world and international fund. But before we get wade into the specifics, let me address your second question.

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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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While I don't think you would be dooming yourself to a post-career life of penury if you skipped foreign stocks entirely, I generally think it's a good idea to include international shares in your portfolio.

Casting your gaze abroad makes sense for a number of reasons, the most important of which is broader diversification. By going international, the prospects for your portfolio -- and, by extension, your retirement -- are no longer tied exclusively to the performance of the U.S. economy and financial markets.

And since markets in different countries don't always move in lockstep with each other, one part of your portfolio may still be able to chug along while another part slows. As a result, a portfolio that includes both domestic and foreign shares should be able to earn long-term returns comparable to those of an all-USA portfolio but with less risk, or volatility.

But you should realize that this extra layer of diversification doesn't protect you from major shocks like the recent financial crisis. Back in 2008, many foreign markets nosedived just as steeply, if not more so, than the U.S. market. Rather, this smoothing effect on returns is something that happens over the long term.

The second thing to understand about diversifying internationally is that it shouldn't be carried out as a short-term guessing game, jumping out of foreign stocks because of recent turmoil in Europe or into them because some economic observers believe the continent's outlook is now rosier than that of the U.S. International investing works best when it's done in a disciplined and systematic way.

Let's move on to your question about the difference between a total world stock index fund and a total international stock index fund. Both types of funds will give you foreign exposure. But there's a key difference between the two. A total international stock index fund spreads its money among the stocks of a broad array of foreign countries, but excludes U.S. shares. It's designed to track only non-U.S. markets.

A total world stock index fund, on the other hand, invests in both foreign and U.S. shares. It takes a global approach, which is to say it tracks the world's stock markets overall.

Now, you might figure that you can get everything you need -- U.S. and foreign shares -- all in one place by just investing in a total world stock index fund. And that's true. But since a total world stock index fund's asset weights are based on stock market values for each country -- and since the U.S. stock market accounts for less than half of the world's total stock market value -- I suspect you're going to end up with a lot more of your money in foreign stocks than you expect, or want, if you go the total world index fund route.

As of the end of June, for example, Vanguard's Total World Stock Index Fund (VTWSX) had roughly 42% of its assets invested in U.S. shares. The remaining 58% was spread among shares of 42 foreign countries, although Japan and Europe accounted for the bulk of it. So if you had a $100,000 retirement portfolio and invested it in this fund, about $58,000, or well over half of your portfolio, would be in foreign shares.

Although there's no "official" percentage of foreign stock that's considered ideal for individual investors, I'd estimate that advisers typically recommend foreign shares represent between 20% and 30% of your stock holdings (although some may go to 40% or more). Clearly, 58% is well above that range and, indeed, more than what Vanguard itself recently suggested "may be reasonable". That figure is also more international exposure than the firm provides in its target-date retirement funds).

So I don't think owning a total world stock index fund alone is a good way to diversify internationally.

I also don't think it's a particularly good fund to combine with your U.S. stock holdings -- say, a total U.S. stock market index fund -- to arrive at whatever domestic-foreign blend you feel is appropriate. Why? Well, unless you're pretty nimble with numbers, arriving at the right mix might not seem very straightforward.

For example, let's say you have a $100,000 portfolio that you want to invest in a mix of 75% U.S. stocks and 25% foreign shares. How would you divvy up your money between a total world stock index fund such as Vanguard's and a total U.S. stock market index fund?

The answer is that you would have to put $43,000, or 43% of your money, into the total world index fund and $57,000, or 57%, into the U.S. index fund. The 42% U.S. exposure in the world fund would mean you effectively have $18,000 (.42 x $43,000) invested in U.S shares in that fund. Add that to the $57,000 in the U.S. fund, and you've got $75,000, or 75%, of your hundred grand in U.S. shares and $25,000, or 25%, in foreign shares.

The presence of U.S. shares in a global or total world fund muddies the waters, so that arriving at and maintaining the mix you want isn't exactly intuitive.

Besides, there's a much easier way. Want your $100,000 retirement portfolio to represent a 75% U.S.-25% foreign mix? Simple. Put $75,000 in a total U.S. stock market index fund and $25,000 in a total international stock index fund. By using one fund that's all USA and another that's all foreign, it's much easier to get to the mix you want (and much easier to rebalance).

This approach is also likely to be cheaper. Vanguard's Total World Stock Index fund charges 0.50% in annual expenses and levies a 0.25% purchase fee that goes into the fund. Expenses for its total U.S. stock market fund and total international stock fund, by contrast, are 0.18% and 0.32% and neither charges a purchase fee. (Both total international and total world also charge a redemption fee of 2% that goes into the fund for shares redeemed within two months).

Bottom line: As a rule, I believe simpler is better. And the simplest way for most investors to add foreign exposure is through a fund that invests in a broad range of foreign shares, and only (or very nearly only) foreign shares. A total international stock index fund is an excellent way to do that, although you can also opt for an actively managed foreign (as opposed to global) stock fund if you're convinced a manager can add value beyond the extra cost.

Whatever your preference, you'll find both types, index and actively managed, on our Money 70 list of recommended funds.