Going overseas without going overboard

Posted by on December 10, 2009 @ 4:09 pm in Investing

The idea of holding a portion of your portfolio in non-U.S. stocks has been around for quite some time, but the ways in and reasons for which it’s put into practice have evolved.

At first, the addition of non-U.S. stocks provided another level of diversification, as these markets did not move in perfect tandem with the U.S. market. Today, it’s harder to discern the difference between markets in the United States and abroad—just consider the events of the past year.

Also, there weren’t initially that many options for individual investors looking to gain access to these investments. Today, there are over 730 funds* that specialize in international stocks (2,600 if you include all of their share classes!).

While many people agree that international investing is a generally solid concept, there remain three fundamental questions each investor needs to answer: (1) Is an international allocation still important? (2) How should I get that exposure? and (3) What’s the right allocation?

The answer to the first question is yes, in my opinion. The initial thinking around holding non-U.S.-based stocks was that they could provide additional diversification and return. Today, the emphasis is more on the diversification benefits. There’s also the opportunistic aspect: Why limit your portfolio only to U.S. companies when there are so many attractive companies outside our borders?

There’s been quite a bit of debate around how to gain international exposure: a direct investment in an international fund, or indirectly, by owning companies that derive a large portion of their earnings outside the United States? While it’s true that many U.S. companies today are global in nature, and their earnings can benefit from economic growth in other countries, the stock performance of these companies will still be most highly correlated with overall U.S. stock performance. Approaching international investing this way may not give you the diversification benefits.

The “how much” decision is complicated by the number of ways to calculate the appropriate international exposure. One way is to hold investments by country according to the percentage of total world GDP each represents. Under this methodology, a U.S. investor’s portfolio would have 25% in the United States and the balance in other countries.** Another way is to divide your portfolio using each country’s market value as a percentage of the total. By this measure, the United States would represent 42% of an investor’s portfolio, and non-U.S. holdings 58%.**

Unless one has the time and resources to keep track of these statistics, it might be better just to hold a flat percentage in non-U.S. stocks. In order to get any meaningful exposure, consider starting with at least 20% of your equity portfolio invested in non-U.S. companies. A higher allocation could be appropriate for investors who wanted more exposure.

There are three other factors to consider. First, many funds that invest in U.S.-based companies may also invest a certain percentage of assets in non-U.S.-based companies. Be sure to factor this into the equation when calculating your portfolio’s overall exposure. Plus, remember that many U.S.-based companies can earn a significant portion of their earnings from business outside the United States. Finally, consider taking a page from the corporate world and making sure that the bulk of your assets are denominated in the same currency as your liabilities (i.e., your spending needs). For most U.S. investors, that currency is the U.S. dollar.

* Source: Morningstar, as of September 30, 2009.
** Source: MSCI, as of September 30, 2009.

Note: All investments are subject to risk. International investments are subject to additional risks, including currency fluctuation and political instability. Diversification does not ensure a profit or protect against a loss in a declining market.

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