Investing overseas: Find the right balance

@Money February 2, 2012: 5:14 AM ET
International markets, roiled by debt woes in Europe and slowing growth in Asia, look like a high-wire act when looking at investment strategies.

International markets, roiled by debt woes in Europe and slowing growth in Asia, look like a high-wire act when looking at investment strategies.

(MONEY Magazine) -- Whoever said that the world can be a scary place sure wasn't kidding. Consider a few of the frighteningly noteworthy events of the past year: Europe's economy slipped into a debt-induced coma; the euro went from being a potential global store of value to a currency on the brink of extinction; and growth in overheated markets like China and Brazil started to slow, prompting a nosedive in their equity prices.

Virtually every overseas market plunged in 2011, with Chinese stocks off nearly 20%, Indian shares down 30%, and Greek equities sinking more than 60%. And with much of Europe still mired in debt and emerging-market leaders determined to keep a lid on their over-heated economies, 2012 doesn't look to be much different.

The timing couldn't be worse for U.S. investors, who in recent years have developed a ravenous appetite for foreign equities.

In fact, since 2007 every new dollar that Americans have put into stock funds has gone into ones that invest overseas, the Investment Company Institute reports. As a result, the average U.S. investor's stake in international equities has grown from around 15% of his total allocation to stocks in 2001 to more than 30% today.

The fact that foreign markets tanked last year is no reason to beat a hasty retreat now. A single bad year -- even a really bad year, like 2011 -- is merely a blip in a long-term investor's portfolio life. Exiting now (or pulling back sharply) robs you of the diversification benefits that overseas investments can provide and shuts you out of the outsize gains they sometimes offer.

If you'd fled after 2008, when every overseas market sank amid the global financial panic and the outlook seemed even worse than today, you'd have missed the nearly 80% gains posted by shares of companies based in emerging economies the next year.

You should, however, take a hard look at your international stocks and tweak your holdings as needed to lessen the risks inherent in foreign markets now.

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The five strategies that follow will help. The first two show you how to get the big picture right; the last three allow you to paint with a finer brush, putting the finishing touches on your portfolio. Get enough of those little things right -- like finding the proper weighting in European equities or the right types of emerging-market funds to own -- and you'll dramatically better the odds you'll come out ahead in the long run.

Strategy no. 1

Stop going overboard overseas

It's become fashionable lately among financial advisers to argue that half or more of your stock portfolio belongs abroad, since a majority of the world's economic activity is generated outside the United States. And with record amounts of new money flowing into foreign equities recently, investors may get there soon -- especially given the accompanying retreat from the U.S. market.

In the past two years investors have yanked more than five dollars out of domestic funds for every two new dollars that have gone into foreign portfolios.

You can, however, have too much of a good thing. And last year's foreign market turmoil did highlight yet again the risks of making too big a bet in any one group of stocks.

Action plan

Cap your commitment. A recent study by the Vanguard Group suggests the maximum you should invest overseas is substantially lower than many experts have been recommending.

Its conclusion: Allocating more than 40% of your stock holdings to foreign equities does not provide additional diversification benefits to your portfolio. In fact, Vanguard found, once you invest more than 40% abroad in a mix of developed- and emerging-market stocks, your portfolio actually starts to deliver a bumpier ride.

Less may be more. Francis Kinniry, a principal in Vanguard's investment strategy group, says a 30% weighting may be all you need.

Historically, he notes, this conservative allocation has reduced the ups and downs of a portfolio nearly as much as a 40% foreign stake did. And over the past five major downturns, that 30% stake would have cut losses by 1.5 percentage points compared with a U.S.-only portfolio.

Strategy no. 2

Don't try to do this at home

Just as it would be wrong to put all your stock eggs in the foreign basket, it's equally risky to avoid any direct exposure abroad.

For example, an oft-recommended, low-risk way to get international exposure abroad is to buy shares of a large, globally minded U.S. company that sells a big chunk of its goods or services overseas.

It sounds safe, but the strategy has limits. For one, shares of U.S.-based multinationals still move more in sync with the S&P 500 than with foreign markets, so you won't get the full benefit of diversification.

What's more, with a multinational-only approach, you'll probably miss out on key opportunities. "Retail is local, and consumers may end up preferring locally and culturally relevant businesses" over U.S.-based multinationals, says Lisa Shalett, chief investment officer for Merrill Lynch Global Wealth Management.

The ideal portfolio mix combines the anchoring effect of big companies in developed markets (both U.S. and foreign) with the pop that carefully chosen emerging-market investments may provide. Here's how you might put that blend together.

Action plan

Start with a core foreign fund. For the bulk of your holdings, go with a fund that tracks a broad index of developed-market stocks. A solid choice: Fidelity Spartan International Index (FSIIX), which invests mostly in Western Europe, Japan, and Australia and is in the MONEY 70, our recommended list of mutual funds and ETFs.

Add a 25% stake in emerging markets. Sure, it's tempting to go bigger; after all, stocks in these countries have produced massive gains of more than 200% since 1999, while the rest of the world's markets have pretty much gone nowhere. Yet you have to be careful.

Emerging-market stocks aren't just riskier than developed-market shares; they can make your overall international portfolio a lot bumpier. A foreign portfolio with 25% allocated to emerging markets fell around 38% during the worst three months of the financial panic in 2008, for example, vs. a 42% loss for one with a 50% developing market stake. An easy, low-cost way to pick up that 25% stake: Invest in Vanguard Emerging Markets Stock Index (VEIEX), another MONEY 70 pick.

Cap it off with multinationals. A classic play is Yum Brands (YUM, Fortune 500), which already has 4,000 KFC and Pizza Hut restaurants in China; more than half of the firm's operating profits through the first three quarters of 2011 came from Chinese consumers. For fund investors, there's Fidelity Export & Multinational (FEXPX), which invests in U.S. firms that sell abroad, such as Apple, McDonald's, and Coca-Cola.

Strategy no. 3

Upgrade your European holdings

The biggest drag on global markets is Europe. From Greece to Italy to Spain, and now possibly France, the problems plaguing the eurozone for more than two years have been spreading like wildfire. The crisis has already battered the euro and plunged the region into what looks like yet another recession.

Check out European markets

Yet there may be a silver lining to the Continent's storm clouds: Expectations there have grown so bleak that even the slightest signs of progress could reawaken European equities in the short run, notes Alec Young, global equity strategist for S&P Capital IQ. In November, for instance, news that the Federal Reserve was working with other central banks to provide cheap funding for European banks sent the global markets soaring briefly.

And because the entire region is selling off in lockstep, you have a unique opportunity to upgrade your European portfolio. Here's how:

Action plan

Lighten up on financials. European banks hold worrisome amounts of sovereign debt, yet the typical broad-based international fund has 16% of its assets in these stocks. One solution: Swap your current foreign fund for T. Rowe Price International Discovery (PRIDX), with less than 8% of assets in banks.

Narrow your target. Another option: Sell a 10% stake in a general European stock fund and replace it with a portfolio that focuses on healthier countries in the region. Switzerland enjoys a strong currency -- the Swiss franc has gained around 20% on the dollar over the past 18 months -- and balance sheet. Its total public debt is only around 40% of the size of its annual GDP, compared with the 150% debt-to-GDP ratio for Greece.

To own the entire Swiss market, go with iShares MSCI Switzerland Index (EWL), whose two biggest holdings are the consumer goods maker Nestlé and the drug giant Novartis.

Slim down your overall stake. Trim your European exposure by 10 percentage points. More could be detrimental.

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