During the 1990s, the U.S. stock market significantly outperformed international stock markets. International investments drew little attention during that time. But now the situation has reversed, with international investments outperforming U.S. stock investments over the past few years. Is now the time to take another look at international investments? Before deciding, consider these points:
Do international investments really add diversification benefits to a portfolio? The primary objective of diversification is to reduce the volatility in your portfolio. For instance, when the U.S. stock market is declining, investments in other parts of the world may be increasing. Over the short term, especially during periods of crisis, stock markets throughout the world tend to move in the same direction. Many believe that the world economy has become more entwined, making world markets more correlated with each other, possibly reducing the benefits of global diversification. Yet, how closely a country's stock market is correlated to the U.S. stock market will depend on how heavily that country depends on exports to the U.S.
One way to determine the diversification benefits of adding an asset class to your portfolio is to review the correlation between the two assets. Correlation is a statistical measure of the extent to which one asset class moves in relation to another asset class, ranging from +1 to -1. A correlation of +1 means the two assets are highly correlated and move very closely together in the same direction. Combining assets with a high positive correlation will not provide much risk reduction. A correlation of -1 indicates the assets move in opposite directions, a rare event in the investment world. A correlation close to 0 means there is no relationship in the price movements of the two assets. Combining assets that aren't highly correlated can help reduce a portfolio's volatility.
A recent study comparing the correlation of returns between the U.S. stock market and major foreign stock markets for the period from 1988 to 2007 found the following correlations with the U.S. stock market:
| Japan | . 35 |
| Pacific region | .42 |
| Australia | .50 |
| Hong Kong | .51 |
| Switzerland | .54 |
| Singapore | .55 |
| Germany | .60 |
| France | .62 |
| United Kingdom | .65 |
| Netherlands | .67 |
| Europe | .71 |
| Canada | .73 |
(Sources: T. Rowe Price Associates, Inc., Standard & Poor's, 2008)
While some of the correlations are relatively high, others are fairly low. Since these correlations relate only to major foreign markets, there is potentially less correlation with developing countries' stock markets. In general, the correlations with foreign markets are still low enough to provide diversification benefits.
Do returns in foreign markets offer greater potential than U.S. stock market returns? No one can predict the future performance of any stock market. However, reviewing past performance can help develop realistic expectations. International investments outperformed the U.S. stock market for five-year rolling periods from 1974 to 1982 and from 1985 to 1990. From 1990 to 2003, international markets lagged the U.S. stock market. Since 2004, international markets have outperformed the U.S. stock market (Sources: The Case for Global Investing, 2005; Diversifying Overseas, 2007).
These returns, however, compare overall international returns to U.S. returns. From 1987 through 2006, the U.S. stock market never had the highest returns out of 10 major foreign markets. In 2002, the U.S. stock market ranked 9th out of 10 markets, 10th in 2003 and 2004, 8th in 2005, and 10th in 2006 (Source: Diversifying Overseas, 2007).
Even though international markets have had higher returns than the U.S. for the past few years, international investments lagged behind U.S. investments for such a long time that there may be opportunities to find investments in other parts of the world that are more attractively priced than those in the U.S.
Does international investing offer other advantages? The U.S. stock market now represents only 45% of total market capitalization in the world, down from 66% in 1970 (Source: Diversifying Overseas, 2007). Limiting yourself to U.S. investments means eliminating over half of the world's investments from consideration. In a number of industries, the world's leading companies are not U.S.-based. Of the top 10 industry leaders in terms of market capitalization, the following were located outside the U.S.:
- 9 in metals and mining companies
- 8 in electronic equipment and instruments companies
- 7 in automobile companies
- 7 in household durables companies
- 7 in telecommunications companies
(Source: Diversifying Overseas, 2007)
Also, since different countries are at different developmental stages or at different stages in the economic cycle, you may find opportunities to invest in trends in other parts of the world that you missed in the U.S.
What percentage of your portfolio should be invested in international investments? It is usually recommended that you allocate at least 10% of your portfolio to international investments, since less than that will typically have little effect on your portfolio's total return. It is common to see recommendations of a 20% to 30% allocation to international investments. Inflows to international mutual funds have increased 89.6% from 2004 to 2007, with investments in international mutual funds comprising 20% of all equity mutual funds in 2008 compared to 18% in 2006 (Source: Bank Investment Consultant, July 2008).
However, what percentage you allocate will depend on personal factors, such as your risk tolerance, time horizon for investing, and comfort level with foreign investments.
International investing may not be suitable for everyone. In addition to the risks associated with domestic investing, foreign investing has unique risks, such as currency fluctuations, political and social changes, and greater share price volatility. Diversification does not ensure against loss.
