Debbie buried her face in her hands. Through our two-way videoconference, I could clearly see her angst about my recommendation. At several other times in our consultation, she shook her head with a frown.
“I have never—NEVER—made money,” she said, “in international stocks.”
It was earlier this year, and Debbie (not her real name) was getting ready to retire. She had contacted Vanguard for advice on how she could best structure her portfolio for this next, great stage of her life.
My advice wasn’t exactly what she was expecting. After learning about her goals and overall situation, and reviewing her existing portfolio, I recommended (among other things) that she invest 100% of the cash she was holding in a fund of international stocks—of which she had none.
“Ugh,” she groaned at one point.
Many investors seem to feel the same way—and did so even before the recent stock volatility associated with global economies. For instance, in a poll of approximately 5,000 Vanguard webcast viewers on international investing held back in May, 63% said they had less than 25% of their portfolio in global investments. My colleagues have also done some extensive research around the issue of home bias.
Which is probably not all that surprising. With all the turmoil of the past weeks, many investors may be asking—especially someone on the verge of retirement—why add to their international stocks or bonds?
The truth is, for investors who have little or no international exposure in their stock and bond portfolios, anytime can be a good time for getting the risk reduction benefits that a globally diverse portfolio offers.
It’s all about diversification
The primary reason to invest internationally? Diversification. For example, as the chart below shows, holding a portion of your portfolio in international stocks—which have more relative risk than U.S. stocks—actually creates a less-volatile portfolio (as illustrated by the chart’s troughs) over the long term.
Non-U.S. bonds can also diversify an all-U.S. portfolio. Many investors don’t realize that the non-U.S. bond market is currently the largest asset class in the world. Including foreign bonds in your mix places your financial eggs in thousands of baskets, spreading out and reducing a portfolio’s overall risk.
Not to say that the returns of international stocks and bonds are entirely uncorrelated with their U.S. counterparts. International and U.S. securities may both go up or down in value at the same time. However, they don’t go up or down to the same degree. Because they’re traded on entirely different market exchanges, they tend to perform differently, which, from a diversification standpoint, is the name of the game.
Bad news doesn’t necessarily foretell bad returns
The main reason I’ve seen most investors shy away from international exposure, especially in the last several years, is headline risk. With all the bad news that’s come out of Europe, Japan, China, and a host of other countries, many investors fear putting any of their hard-earned money overseas.
But following headlines is a poor way of making financial decisions. One example I love is 2012, the year that the news was full of Greece being on the brink of insolvency (the first time) and the impending collapse of the euro zone. Numerous investors I talked to that year didn’t want to discuss increasing or adding international stocks to their portfolios. But compare the surprising returns of international and U.S. stocks by year-end:
And while international stocks posted negative returns in 2014, they again surprisingly outperformed U.S. stocks through the second quarter of this year, until the most recent global market swoon. Negative headlines don’t necessarily equate to negative, or even trailing, performance, either internationally or domestically.
It can pay to truly own everything
It is important to remember that the diversification benefits of investing outside the United States don’t result from the investment potential of one particular country’s market. By owning the entire global market (just like owning the entire U.S. stock market), you participate in the growth of economies that are doing well, without having to guess correctly in advance which ones have the best potential.
A second reason investors give for avoiding international investments is that they believe owning large U.S. companies like Coca-Cola or McDonald’s provides international diversification through the companies’ huge overseas revenue streams. However, revenue diversification and stock diversification aren’t the same. When it comes to stock performance—which is what matters most in your portfolio—much of it is driven by fluctuations of the different stock exchanges on which the multinational companies (domestic or international) are traded, regardless of where their revenues come from.
So how much international exposure should a portfolio have?
When my Vanguard Personal Advisor Services colleagues and I manage portfolios for our clients, between 30% and 50% of stock holdings are international (depending on different factors, including the capital gains tax consequences of changing a client’s existing holdings). That’s in line with the risk reduction benefits highlighted in the chart above. On the bond side, we keep between 20% and 40% in foreign holdings.
Some investors are shocked by the size of those percentages. In my experience advising Vanguard investors managing their own money, most tend to have far less, maybe 10% or 15% total in each. They might get an emotional benefit from feeling they are helping their portfolios while avoiding risk, but as the chart above indicates (from a stock standpoint), they’re not getting much else.
World events have made international investing a tough sell these past few years. But for long-term investors, the diversification benefits of holding meaningful allocations to broad U.S and international stock and bond markets remain unchanged—even if returns are hard to look at in the short-term.
In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.
Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issues by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates.