How foreign stocks fit into your portfolio
International stocks should be a part of any diversified portfolio, but they're not a shelter against domestic rough spots.
Question: Given the way the U.S. stock market has been behaving, what are your thoughts of buying foreign stocks versus domestic shares? —Henry, San Antonio, Texas
Answer: If you’re thinking of moving into foreign stocks because they’ll offer shelter at a time when U.S. shares are being hammered, you may end up being disappointed. Academic research has shown that when the U.S. stock market gets slammed, foreign bourses also find themselves reeling.
That’s certainly been true lately. Foreign shares as measured by the broad MSCI EAFE index, are down about 19% from the beginning of the year compared with a 12% decline for the Standard & Poor’s 500 index. And some foreign markets have taken an old-fashioned whupping: witness the drop of just over 50% in the value of Chinese shares in the Shanghai Composite Index.
Similarly, if you’re being drawn to foreign shares because they racked up big gains before their recent setback, you may need to re-calibrate your expectations a bit on that front too. Some of those attractive returns were the result of a slide in the value of the U.S. dollar. American investors who own foreign stocks benefit when the greenback drops and foreign currencies rise since profits in shares denominated in foreign currencies buy more U.S. dollars. With European economies weakening and commodity markets struggling, however, the dollar has been rallying lately. Which means that currency tailwind effect could abate, or even turn into a headwind.
Why invest overseas?
So if foreign stocks may not provide the security of higher ground during a deluge and the dollar’s recent booster effect may be waning, why do I still think it’s a good idea for U.S. investors to have a portion of their portfolios invested abroad?
The answer is that, propelled by growth in their economies, foreign shares can generate strong long-term returns aside from any currency effect. And despite foreign stocks’ tendency also to retreat when U.S. shares drop sharply, foreign equities still offer valuable diversification benefits during those times when the U.S. stock market isn’t operating in bear mode, which, after all, is most of the time.
Analysts measure the extent to which domestic and foreign stocks zig and zag relative to one another by looking at a statistic known as the correlation coefficient. The propensity of domestic and foreign shares to move together can vary for a number of reasons, including trade policies and a general move toward globalization. But over long periods of time correlations are generally loose enough so that adding foreign stocks to an all-USA portfolio can enhance the tradeoff between risk and return (that is, boost your portfolio’s returns without increasing risk or deliver the same return while lowering risk).
Build a portfolio
There are several ways to reap this benefit. One is to create a portfolio diversified by industry sectors (consumer staples, financials, technology, etc.), and then buy stocks of the best companies in those industries whichever country they happen to be located in. While this approach can be effective, it requires quite a bit of time, effort and skill to identify top companies around the globe and then monitor such a portfolio.
Another strategy is to add international exposure country by country, depending on which nations you feel offer the best opportunities for diversification and return. There are certainly enough single-country and regional mutual funds and ETFs around to allow you to take this route if you wish. But pulling it off successfully assumes you know which countries to buy, how much of your portfolio you should devote to each and how to keep tabs on and adjust your far-flung holdings.
And then there’s a much simpler approach that I believe is appropriate for most people – just devote a portion of your stock portfolio to a broadly diversified international stock fund. You can find suitable candidates by checking out the actively managed, index and ETF sections of our Money 70 list of recommended funds.
Reasonable people can and do differ as to how much exposure to international markets individual investors ought to maintain. But, I think 20% to 30% is a sensible range.
Stay the course
Whatever percentage you decide is right for you, the important thing is that you largely stick to it. In other words, avoid the temptation to plow more money into foreign stocks when they’re outpacing U.S. shares and to scale back your international holdings when domestic stocks are surging.
There are no guarantees, of course, but over time the approach I’ve outlined should enhance your portfolio’s overall returns and reduce risk. Not eliminate risk, mind you. You’ll still have to deal with periods when both U.S. and foreign shares slump. But that’s what bonds are for.
Fred in Albuquerque, I sort of agree with your reasoning, just not to the extent to which you've taken it. I too have a relatively secure job in the US, and as a citizen with no foreign relatives much of my fortune is tied to the that of the US. Therefore, roughly half of my investments are overseas – for diversification of risk and potential gain. A risk, as pointed out in the article, is that many countries economies are closely tied to the US. Consequently, I've been more focused on nations like India and South Africa that are growing and relatively democratic but are not bound to us like China and much of Europe. In fact, most international funds I've looked at focus on Western Europe and Japan, including the iFund in my TSP (which is like a 401k for federal employees), so I try to balance this out in my IRA. I think your choice of the VGTSX is better than most in that it is broad, but I do have to balance what is available to me. As for Roth IRA's, I agree with the more conventional wisdom that it is best to diversify tax-wise, too, so I max out my RothIRA contribution ($5,000/year), and now my goal is to eventually be able to maximize my TSP contributions ($15,500/year), although I am a long way from that because my salary is still less than $30,000 a year. I have other sources of income, but they are less reliable, and I have a mortgage.
Another important way to protect from being too closely bound to the US economy is to buy multinationals that get significant business overseas, which I do with American and foreign companies, although mutual funds/ETFs are best for most people (and probably for me, too, even though I enjoy buying individual companies).
A third important way to diversify out of the US economy is to purchase assets that hold their value despite what happens to our economy and inflation. Many people view real estate and inflation-indexed bonds as a way to do this, which I think is the wrong reason for the right thing – these assets bring diversity, but are still tied to the US, and the government understates inflation. That leaves commodities and precious metals, which have experienced a runup in recent years. However, I still think that averaging into metals is a relatively safe way to diversify out of the US – if you keep the percentage reasonable. I used to like iBonds, but with them paying 0%+CPI, they don't look too attractive considering A, the government understates the CPI and B, if inflation does come under control, you aren't earning anything. So, Gold and Silver it is for me, although I already have a high enough percentage considering my US stock declines over the past year.
In short, most of my money goes overseas, too, although I could never go 100 percent.
I had an overseas mutual fund in the 90's, and for years it didn't return much. However by 2003 I had 100% of my 401(k)s in VGTSX and similar investments. Worked out great! A year ago I pulled it all out into money markets, which has also turned out great, so far…. I plan to get back to 100% VGTSX / I-Fund where I'll leave it for many years….
My thinking is this: If America has a great economy, interesting, good paying jobs, then I may never want to retire, and I won't care if I ever see my 401(k) money again. However, If current trends in our education system continue, and the interesting, high paying jobs end up in a prosperous rest-of-the-world, then at least I'll have a fat 401(k) to live off of.
Same thoughts on conversion of 401(k)'s to Roth IRA's. Stupid I think. Sure taxes may go up in the future, but maybe those will be VAT / Sales taxes (consumption oriented)! But mostly, my pre-tax 401(k) functions like an insurance policy for me. If I end up a poor old man, I'll pay very little taxes, because I'll be in a low tax bracket. If I end up a rich old man, with lots of other investment income, I'll pay more because I'll be in a higher tax bracket. But hey–that's because I'm a rich old man.
I personally plan to eventually get to 40% international, split between an MSCI EAFE index fund, a large cap developed markets fund, a small cap fund and an emerging markets fund