DAVID PEARTREE, THE DAILY RECORD NEWSWIRE
Recent events give investors plenty of reasons to fret about the international markets. The Chinese stock market is in turmoil, the saga in Greece is ongoing, and upheaval in the Middle East is spilling into Europe.
Longer stretches of history offer plenty of other reasons to question the merits of investing overseas: wars, financial crises, terrorism, political upheaval, government confiscation, corruption are just a few. Of course, some of those same concerns could apply to investing in the United States as well.
The question for investors is whether there is anything to be gained by investing overseas that can't be found with investments here at home. The answer, notwithstanding the underperformance by international stocks over the past five years, is "yes."
The benefits of owning international stocks boil down to diversification. The admonition to diversify is so basic and oft repeated as to be banal. Investors may forget how it works and why it is so important.
The purpose of diversification is not to enhance returns; the purpose of diversification is to reduce risk. There is no good reason to expect that diversification will provide investors with higher returns than if they did not diversify. Over the long term it is reasonable to expect that the stocks of various regions of the world will provide substantially the same return as can be found in the U.S.
If it were otherwise, if one region could be expected to offer higher prospective returns, then investors' dollars would flow to those markets and that, in turn, would bid up the prices of that region's stocks. As prices match and then exceed fair value, the long-term return prospects would decrease and those higher prospective returns would vanish.
So, if the long-term returns for all stock markets are expected to be essentially the same, why invest overseas?
First, because there is always the possibility that a particular market does in fact produce better long-term returns for reasons not now readily apparent. The United States now accounts for less than one half of the global equity markets. Investing only within the U.S. excludes more than half of the available stocks. Investing overseas creates the opportunity to own more winners.
More importantly, investors should invest overseas because diversification reduces risk. Basic portfolio theory tells us that a combination of two risky asset classes in this case, U.S. stocks and international stocks is less volatile than a portfolio owning just one asset class.
That's because the returns from international stocks can vary significantly from U.S. stocks in any given year. U.S stocks have outperformed the international markets over the past five years, but for most of 2003-2008 international stocks outperformed. U.S. stocks dominated in the 1990s but even then international stocks took the lead for a brief stretch mid-decade. Over the past 45 years, the lead has changed roughly every four or five years.
The less-than-perfect correlation between the two asset classes means that a portfolio comprised of both should be less volatile than either asset class alone. Over the past several decades, most individual countries have experienced higher volatility than the U.S. stock market. Emerging markets have experienced even higher volatility. Yet, the broadest global index, which includes the U.S., international developed and emerging markets, experienced the lowest average volatility of all.
But why is it not good enough simply to own multinational stocks? By some estimates around 40 percent of the profits of the S&P 500 companies derives from revenue earned overseas. To a degree, multinational stocks like Caterpillar or McDonalds capture international stock market returns indirectly.
While true, it excludes over 50 percent of the opportunity set represented by other leading global companies many of which, like Nestle or Toyota, are household names here even though they are based in other countries.
It also ignores the fact that U.S. and international stock markets have very different sector exposures. The U.S. stock market offers greater exposure to the information technology, computer hardware, biotechnology and software sectors. International stock markets offer greater exposure to consumer goods, industrials, basic materials, and financial companies.
The optimal allocation to international stocks is a judgment call. The optimal allocation probably varies over time. The volatility of stock markets and the correlations between stock markets changes over time. The exact, optimal allocation is a moving target. There is no way to know today what allocation will produce the best investment results in the future.
On the low side a stock allocation with at least 20 percent in international stocks starts to provide substantial diversification benefits. On the high side, once the allocation to international stocks exceeds around 40 percent the diversification benefits are diminishing.
It matters less whether the allocation is 20 percent, 40 percent, or some other number. It matters more that the investor sets and maintains a strategic target for international stock exposure.
Over the long haul, it should make for a smoother ride.
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David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625, david@worthconsidering.com.
Published: Fri, Sep 18, 2015
