The U.S. is a mess. Should we invest overseas?

By Walter Updegrave, senior writer

(Money Magazine) -- Question: Looking into the future of the American economy, I see tons of debt, the yoke of increasing social spending, pork-fed bureaucratic waste, the exporting of jobs and the importing of poverty. While this may paint a negative picture, I feel it's reality. We all want to be patriotic, but aren't there more fiscally responsible places to invest in that may offer a better landscape? --Dave, Bethlehem, Penn.

Answer: When I was a teenager back in '60s, a gravelly voiced folk singer named Barry McGuire hit the top of the popular music charts with a tune called "Eve of Destruction." The song was basically a recitation of all the problems plaguing the U.S. and the world -- racial strife, violence in the Mideast, the threat of nuclear Armageddon -- with the end of each verse suggesting, per the title, that we're on the eve of destruction.

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).

So what's this blast from the musical past have to do with your question?

Well, if you look at the economic and financial data floating around today, it's hard not to come away with the same sense that we're on the road to perdition. Last week the U.S. Commerce Department reported that past quarter's already lackluster 2.4% annual growth rate for the economy was being revised down to 1.6%. Not exactly the torrid pace you like to see in the initial stages of a recovery. That disheartening news followed an equally gloomy report that new home sales had dropped 12.4% to a record low.

Take a gander at the Financial Report of the United States Government -- the government's version of a corporate balance sheet and income statement -- and you'll see that the long-term outlook isn't exactly rosy either. The "Federal Government's Financial Position and Condition" table on page 3 shows the government's costs exceeded revenues (mostly taxes) by some $1.3 trillion in the last fiscal year and that liabilities exceeded assets by $11.5 billion.

Check out Table 6 on page 158, you'll find that the present value of the excess projected future costs of Social Security and Medicare over future income amounts to a staggering $107 trillion.

But as sobering as much of the info that washes over us these days may be, you've got to step back and get a little perspective.

In times of great turmoil, it's natural to see things in the worst light. Investors felt similar trepidation about the future of the U.S. economy and financial markets during other periods of upheaval, such as the 1930s Great Depression and the severe recessions of the 1970s and 1980s. That apprehension is the major reason investors fled U.S. stocks during those periods, much as they're doing today.

But just as it was wrong to react with irrational exuberance when things were going swimmingly in the go-go '90s, so too is it a mistake to get carried away with pessimism when conditions are tough. The U.S. has rebounded from many rough patches in the past, in large part because our economy, financial system and our people are flexible and willing to adapt to changing circumstances. Indeed, despite Barry McGuire's dire forebodings back in the '60s, both the U.S. and the world not only muddled through, but achieved unparalleled levels of prosperity over the ensuing 45 years.

That's not to underestimate the magnitude of the troubles confronting us. I agree they're daunting. And given today's low yields and iffy growth prospects, it certainly wouldn't seem prudent to expect stocks to deliver their historic long-term 10% annualized gains going forward. In fact, the man largely responsible for compiling stocks' track record, Roger Ibbotson, told me in a recent interview that he thought an average of 8% or so seems more plausible.

But however anxious you may feel about the U.S.'s economic future, it would be a huge overreaction to decide to not to invest in the world's largest economy and stock market because it faces formidable challenges.

For one thing, we're not the only country that must come to grips with issues like burdensome debt and the rising cost of entitlements. Moody's Investors Service recently noted that slimming down government spending and dealing with high levels of debt make slow growth the greatest challenge facing Europe.

So it's not as if you can scan a map and easily home in on countries that don't have some set of daunting economic issues to grapple with. And even if you were able to find an economic utopia, it doesn't necessarily follow that its markets would offer outstanding returns. Presumably, such a Shangri La would attract tons of attention -- and money -- from other investors as well. It wouldn't be long before enough dough had flowed in to bring expected returns, on a risk-adjusted basis at least, in line with the rest of the world.

Given all this, I'd say the preferable approach is to diversify that is, invest in the U.S. and internationally. Reasonable people can disagree about how much of one's portfolio belongs in foreign vs. U.S. securities. I believe keeping 10% to 20% of one's stock holdings in foreign equities allows you to reap most of the benefits of diversification, although some advisers recommend upwards of 30%. Whatever level you decide is right for you, you can get that exposure in one mutual fund by buying a total international stock index fund.

If you develop insights into which foreign markets have better prospects than the U.S., you can easily overweight them by investing in mutual funds or ETFs that concentrate their assets in specific regions (Latin America, Europe, Asia, etc) or even particular countries. (For a list of nearly 200 ETFs that invest in foreign shares, go Morningstar's ETF Performance Table, choose "International" on the pulldown menu and then click on the "Show Complete List" button.)

I'd be wary, though, of straying too far from the country weightings of a total international stock index fund. And I'd be especially careful about loading up heavily on shares of small volatile emerging-market countries, as they can be quite risky.

Bottom line: Your instinct to expand your investing horizons beyond America's borders is a sound one. But predicting which countries' markets will deliver the best gains in the future is a guessing game at best. So rather than try to identify tomorrow's winners, diversify your portfolio across a broad range of countries. And despite your misgivings, include the U.S. To top of page

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