Investors cast nets all over the globe in the name of diversifying portfolios, but sometimes a little of a good thing can turn into too much. Such may be the case when it comes to pouring foreign equities into your investing plan.
At the end of 2008, U.S. stocks made up 45 percent of the global equity market, according to Vanguard. While there's no exact consensus on the precise proportion of foreign stocks to domestic stocks that one should own, research shows that erring on the side of having too little can be better than having too much. For instance, here's what Vanguard's article on the subject has to say.
From "Considerations for international equity":
U.S. investors have obtained substantial diversification benefits from relatively modest international allocations ... A 10 percent allocation to international stocks historically reduced the volatility of a U.S. only equity portfolio by 44 basis points, while a 40 percent allocation has historically reduced volatility by 95 basis points. In other words, a 10 percent allocation would have delivered 46 percent of the maximum benefit of 95 basis points. Allocating 20 percent to international stocks would have reduced average portfolio volatility by 75 basis points, or 79 percent of the maximum benefit.
Research by Dave Loeper, founder of Wealthcare Capital Management, shows that maximum diversification benefits appear from an allocation to foreign equities of between 10 and 20 percent.
Loeper looked at rolling three-year periods over 41 years of returns of stocks from Europe, Australia, and the Far East, or EAFE.
The bottom line on foreign equity allocation was that investors could get the most bang for their diversification buck by keeping allocations to non-U.S. stocks in check, he found.
"You get risk reduction, but only to the extent that you put no more than 15 (percent) or 20 percent allocation to foreign (stocks) in your portfolio," says Loeper.
Loeper's research found that in the 20-year period between 1971 and 1990, higher allocations to foreign equities boosted returns. Over the next 20-year period, higher allocations to international stocks pushed returns down. Over the entire 41-year period, increasing allocations to international stocks would have resulted in increasingly lower returns.
"What is the purpose of putting foreign (stocks) in the portfolio if there are 20-year periods when it helped and 20 years that it hurt? Neither one is more important -- all it means is that it is uncertain whether you would get any return enhancement," Loeper says.
"I would say don't take the extra risk, and don't pay the extra expenses. There will periods of time that foreign stocks outperform and periods when they underperform. But (it) is going to reduce the uncertainty of your portfolio," he says.
According to Loeper, one of the commonly cited reasons that investors should branch out into emerging markets is for their fast gross domestic product growth. But, he points out, stock market returns have little to no correlation to a quickly growing economy.
"They are still unrelated, even for emerging markets," he says.
If GDP was a predictor of stock market returns, "Every company would move to emerging markets to increase their stock price," Loeper says.
How much foreign stock do you own?
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