In recent years, there’s been a lot of noise in the investment world about how increasing globalization has eliminated the diversification benefit to owning foreign stocks. Don’t believe it. Foreign stocks continue to provide diversification and should be part of any efficient portfolio.
But how much is the right amount?
Balancing Domestic & Foreign Stock Exposure
This table provides a look at the annual returns and standard deviations of some S&P 500 and MSCI EAFE blends (EAFE is an industry standard proxy for the stock markets of developed international countries) from 1970 through 2022*.
Average Annual Return
Although the differences are modest, we see that the 75/25 U.S. to foreign blend had the highest return and the lowest volatility of these choices. Higher return coupled with lower volatility is very rare and very desirable.
For the last decade, foreign stocks have generally outperformed. Thus, some have come to believe foreign, and especially emerging markets, are a better investment. Much the same was said about the U.S. at the end of the 1990s. There is no good reason to think one will do better than the other over very long periods of time. If domestic and foreign stocks continue to have very similar performance, then the benefits of diversification will continue to be modest. But the point of diversification is to protect against the possibility of future poor performance.
Some people point to the higher volatility of foreign stocks as a reason why they should provide higher returns. But the reason for the higher volatility is because of currency fluctuations – not the stocks. As the dollar goes up and down relative to other currencies, it reduces or increases the returns of foreign stocks for U.S. investors. This leads to more volatility.
The bottom line is that for very long periods of time, return expectations for foreign and domestic stocks should be essentially the same. This gives us the following logic to build from:
Foreign and domestic stocks are highly – but not perfectly – correlated.
Their long-term return expectations should be about the same.
Volatility is slightly higher for foreign stocks.
Based on these three observations, modern portfolio theory dictates that rational investors should own a blend of the two, with a heavier weighting toward U.S. stocks.
We believe foreign stocks should represent about 30% of total equity exposure for most U.S. investors. This approximately maximizes the diversification benefit without taking too much risk if the U.S. dollar goes on a long run.
Anything in the 20% to 40% range makes sense for most people. As of this writing, about 60% of the value of global stocks is in U.S. companies. This means our recommendation significantly underweights the U.S. relative to the global market.
For similar logic, we believe about a third of international exposure should be emerging markets such as China, India, Russia and Brazil, and about two thirds in more stable developed markets.
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*Figures from June 2022.