Everything is connected in today's global economy. The economies of first-world countries are increasingly linked as is the performance of company stocks in those countries.
Though the correlation between foreign and domestic stocks is fairly high, they don't move exactly in lock step. That's why investors get the benefit of diversification when they branch out to other countries.
Theoretically, when American large-cap stocks are struggling, big companies based in Europe might be doing well. Holding noncorrelated asset classes can reduce the overall volatility of a portfolio.
But the risk-reducing benefits of diversifying internationally quickly vanish when your allocation increases above a certain point.
Recent research by Dave Loeper and his team at Wealthcare Capital Management investigated the amount individuals should invest in EAFE stocks, which would be companies based in Europe, Australia and the Far East.
The sweet spot, according to Loeper, is to have somewhere around 15 to 20 percent of a portfolio devoted to foreign stocks.
"The theoretical benefit we get from foreign allocation should be risk reduction diversification benefit," he says.
But putting too much toward foreign stocks can increase volatility in your portfolio without corresponding returns.
"We don't think it's wise to speculate on the notion that you're going to get a higher return, as those returns are all over the map. There are periods and times where there is significant outperformance in foreign, and there are periods of time when there is significant underperformance," Loeper says.
"There have been long periods where foreign stocks underperformed domestic stocks by 800 basis points a year. Experiencing a decade with half of your portfolio underperforming domestic equities is a pretty big downside," he says.
The added risk doesn't necessarily lead to better returns, just more volatility. Investors with a high tolerance for risk may put themselves through unnecessary pain in hopes of better returns.
"This is the big problem we have in the industry: Most people are of the mindset that you identify your maximum tolerance for risk, and then that’s the portfolio that you use. That makes no sense. You're saying how much pain can you bear, and then position yourself to experience that," Loeper says.
Instead of turning the dial to maximum risk, Loeper recommends figuring out the minimum level of risk necessary to reach your goals.
How much do you invest in foreign companies and why?
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