Diversification. If you’ve done some investment, even as a beginner, you’ve probably seen this word thrown around a bunch of times. Maybe you’ve settled your investments on your S&P index funds or Dow Jones index funds as your “diversification” and called it a day.
While it’s true that these funds offer convenient diversification for your investment portfolio, there’s a huge area you might be overlooking: the international market.
According to the MSCI All World Index, 41.34% of the global market is international (outside the U.S.). There’s a whole world out there where investment opportunities are ripe for picking. Could you be missing out on the growth of developing economies around the world?
Here’s the short answer if you don’t like reading: put about 30% of your portfolio in international stocks to reduce the volatility of your portfolio and call it a day. And no, you’re not missing out on some insider-secret about an upcoming boom in international equities.
You might be thinking, let’s just look at historical data and see whether the U.S. stock market or the international market gives a better return. It’s true that historical data is very important information to base our decisions on (although historical data is not a guarantee of future performance). But in this case, no market, U.S. or international, is consistently better than the other.
Fidelity did a comparison of the U.S. market (represented by S&P 500 Total Return index) and the international market (represented by MSCI EAFE index). One of their major findings was that the annual return on investment is cyclic: one would outperform the other for certain years and then the cycle reverses.
Note that while the relative returns are cyclical, that doesn’t mean you can reliably predict when one market will outperform the other. Because of this, it’s advised to invest in both to reduce the volatility of your portfolio rather than trying to flip flop between one or the other.
However, if we compare the average annual returns, we see that U.S. stocks generally outperform international stocks with a 9.9% and 6.6% annual return respectively between 1986-2018. The greater average returns of the U.S. market is a big reason many investors prefer to devote more of their invest portfolio to U.S. stocks.
Opinions on International Investing
Of course, there are different opinions as to how much people should invest in the international market ranging from nothing at all to all in. Here, we’ll look at these opinions and the reasons behind them.
Don’t invest anything in international equities
One popular opinion is to not invest anything in international stocks at all. Some famous investors including Warren Buffet hold this view.
Warren Buffet has been consistently suggesting ordinary investors to stay with U.S. stocks and to not bother with international stocks. Similarly, Jack Bogle also takes an anti-international stance in buying stocks. They are both very confident in the U.S. economy and believe that it will outperform the global economy both now and in the future.
Note that they don’t claim this view is based on research or cold hard facts. It’s more like a suggestion for normal investors who want to keep things relatively simple.
There are several relatively small reasons that may turn people off from buying international stocks:
- Many big U.S. companies have business around the globe, or have large parts of their operations overseas, so their performance partially captures the performance of the global market. The factors that affect the movements of the global market have the same effects on these companies thus their stock price. A large portion of their revenue also comes from the international market.
- Note: Fidelity pointed out that this is a myth. While a U.S. based company might have operations in foreign countries, its stock price may still be highly correlated to the U.S. stock market. You will likely achieve greater diversification by investing in international stocks specifically.
- They are usually more expensive. International stocks usually have a slight higher expense ratio, usually about 0.01% higher or $1 for every $10,000 invested. However, in most cases, this is too small of an amount to worry about. It’s almost like picking up pennies off the ground at that point.
- They are more subject to things like currency control/currency exchange rate changes, political/economic/social events, policies, etc. There is just more unpredictability and unknowns in general.
- International stock funds are often less tax efficient. For various reasons, like less liquidity or higher dividend yield, the potential amount of returns lost to taxes is often higher for international stock funds. There can be some tax benefits like foreign tax credit, but we won’t get into that here.
- If you want to actually research international companies to decide what stocks to buy, it can be difficult because their information may be not as accessible as U.S. companies, and maybe in another language. But If you just want to buy some international funds, you probably don’t need to worry about this.
- Historically, foreign stocks have yielded lower annual returns compared to U.S. stocks. Between 1986-2018, U.S. stocks yielded 9.9% per year on average while foreign stocks only yielded 6.6% annually. Putting everything in U.S. stocks is betting that the higher yield trend will continue into the future.
Invest Some reasonable percentage
The two main reasons for holding some international stocks are risk management and growth value.
In terms of growth, some international markets might be less developed than the U.S. market, but are rapidly developing and have great potential. There may be countries out there on track to follow the economic success of the U.S. in upcoming years. You can think about it as trying to invest in the next Facebook or Tesla overseas.
In terms of risk management, although markets are greatly correlated on a global scale, the performance of the U.S. and international stocks has not been perfectly correlated. So international investing adds diversification to your portfolio from another dimension and spreads the risk.
That’s often the primary reason for putting a certain percentage of your portfolio in international stocks. From historical data going back to 1970, allocating about 30-40% of your portfolio in international stocks has resulted in the greatest reduction in volatility (a 5% reduction).
Vanguard, a famous U.S. investment advisor group states on their website that their research shows “holding some portion of a diversified equity portfolio in international equities” effectively help mitigate the volatility of U.S. market, and “the majority of the benefit is achieved as the international allocation increased from 0% to 20% of total equity exposure, with incremental additional benefit up to 50%”. Therefore, they suggest that “an allocation that falls between 30% and 50%” is reasonable for most investors.
Similarly, Fidelity also suggests a 30-50% percentage investment on the international market in order to help “provide an appropriate level of diversification and enhanced portfolio risk-adjusted returns”.
Some believe in a 50% allocation to international stocks. This is based on the fact that the global stock market is approximately 50% US and 50% international. The idea is to invest in proportion to the market weight.
People who hold this view think that the phenomenon that international stocks have mostly underperformed U.S. stocks during the last decade is only temporary. They see great potential in international markets in the future with the added benefit that international stocks can be bought at a relatively lower price today.
More importantly, they believe that this is a sensible decision based on the market, and owning a globally diversified portfolio is a smart move in the long run. For a more detailed analysis of this view, check out Laminar Wealth’s article on the case for international stocks.
Invest the Majority of your portfolio in international stocks
A very small percentage of investors choose to invest the majority of their portfolio in international stocks. They are pessimistic about the U.S. economy and believe it’ll be outperformed by the international economy in the future.
This is likely not founded on solid facts or reasoning and is pure speculation. As a general rule of thumb, investing on speculation (or even based on research-backed stock movement predictions) is unlikely to give you consistent, above-average returns on your investment in the long run. Even experts can’t beat the market, why would you?
It’s generally advised for your portfolio to have around a 30% allocation in international stocks, but no more than 50%. The reason for this is to reduce the volatility of your portfolio in the event that the U.S. severely underperforms the international market. While it does not necessarily guarantee you greater revenue, your portfolio will be more protected from sharp dips in the U.S. stock market.
In the end, there’s no “rule” that you must invest in international markets. Warren Buffet himself recommends putting everything in U.S. markets. It’s ultimately up to you to decide how much you want to put in international stocks and diversify your portfolio. But if you just want a number, 30% is a good middle-ground stance.
Check out these related articles to learn more about investing:
- Stock Market Investing for Complete Beginners: the Complete Guide
- Retirement Investing for Beginners: the 401(k) and IRA explained
- How to Build an Investment Portfolio for Complete Beginners
- How Much Percent Of Your Portfolio Should Be International Stocks? - September 28, 2020
- Why is Day Trading Restricted - September 21, 2020
- How Long Do I Have To Wait To Buy A Stock After Selling It? - September 14, 2020