Creating your asset allocation is one of the most important steps in designing your written personal financial plan. Yet it’s easy to get stuck on this step wondering, “What percentage of X investment should I include?” One common question is, “How much international stock exposure should I have in my portfolio?”
Let’s address that question here.
Of course, it’s personal
Isn’t that an amazing qualifier?!
But it’s important to say out front. Everyone’s plan will be different and need to be tailored to you. The best way I’ve heard it put is that you need to balance your ability to eat (get good investment returns) with your ability to sleep (minimizing volatility). And everyone’s eating/sleeping point will vary.
So where does an international stock portfolio come in to this?
Well, in general, international stocks are considered risker than US stocks. The reason for this is related to the stability of foreign economies, governments, and currency among other factors.
The more stable the International entity, the less potential risk.
But with risk comes reward
Just like anything in investing. Investors expect to receive a greater potential return as the risk of an investment goes up. This potential greater return is tied on the flip side to a potential greater loss.
On the whole, international stocks taken together in one bushel have greater risk than US stocks. So they also offer higher potential return in exchange for this risk and volatility.
But all international stocks are not the same
For instance, developed foreign country common stocks have behaved pretty similar to blue chip US stocks. Maybe the expected return for both of these are around 5.5-7% annually. And the expected volatility is about 25% of their value.
Meanwhile, developing country or emerging market stocks are more risky. Their expected returns run around 8-9%. But investors should be ready for fluctuations of 50-75% of the stocks’ value in any given year.
Watch Jordan’s Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here!
So, how do we harness these to our advantage?
The same way as always, of course!
I don’t recommend buying individual foreign stocks of any variety. The same way I don’t recommend you do that for an US stocks.
I also don’t recommend just investing in any one type of international stock, like emerging market or developed country.
Like US stocks, the international stock market trends up over the long run when taken as a whole. This is due to the increased risk involved, yes. But what you are really betting on is the ingenuity of the world economy. And that’s a safer bet than on any one company.
That’s why index funds rule supreme for the international stock market as well as the US stock market.
If you are including International stock in your portfolio, it should be in the form of index funds.
But I still haven’t answered the main question from the very beginning of this post…
How much international stock should be in your portfolio?
Simply…what should be your asset allocation for foreign stocks.
Do you need to have international stock in your portfolio?
No you don’t.
- Save 20% of your income
- Invest in index funds
- Let compound interest work it’s magic over an extended period
- Retire on your terms when you reach your goal nest egg
And you can invest in a very simple 2 fund portfolio of just a total US stock market index fund and a total bond market index fund.
That is 100% fine!
If this is 100% fine, then why even talk about an international stock portfolio?
A very valid question. And one that has a good answer.
The reason is that in theory it will actually increase the returns and decrease the volatility of your portfolio. That means that you eat better and you sleep better. Win-win.
Want some proof?!
Check out the graph here that I’ve borrowed from the book, A Random Walk Down Wall Street.
In the bottom left corner, it shows a portfolio of 100% US stocks (represented by the S&P 500) with returns averaged from 1970-2017 (measured on the y-axis). As you travel along the drawn line, the portfolio makeup shifts to more and more international stock exposure.
What you notice is that the 100% US stock portfolio has a relatively lower return with a low volatility (measured on the x-axis). And a 100% foreign stock portfolio has a higher return but also much higher volatility. This is expected due to the riskier nature of the foreign stocks.
But something unexpected happens between these two points
When you start adding international stocks to the 100% US stock portfolio, the return initially goes up (which we expect), but the volatility initially and surprisingly goes down!
Now the trend reverses as more and more riskier international stocks are added and the volatility increases. But this initial increase in return and decrease in volatility is a nice little surprise!
But how exactly does this work?
The answer is diversification and incomplete correlation. Basically incomplete correlation is why diversification works in investing.
When two investments don’t correlate completely, that means when one goes up the other may stay the same or fall. And vice versa. And all other combinations of possibilities.
In our example, it means that poor returns from US oil companies in balanced out by good returns in foreign oil companies. And on and on.
These offsetting movements initially reduce volatility despite increasing return via the overall increased risk of foreign exposure.
What is the sweet spot?
It turns out that based on these historical numbers, an 18% exposure of your stocks to intentional markets will increase your risk and decrease your volatility the most.
Critiques of international stock portfolio exposure
The biggest critique of these arguments is that the correlation between US and foreign stocks is growing closer to 1 due to globalization.
If these investments are perfectly correlated, then any offsetting action resulting in the diversification benefits above go away. And there is some evidence of this. In the 2007-2009 bear markets, both US and intentional stocks tanked. Moreover, studies show the correlation between these two entities rising over time.
However, that correlation is still very far from being 1. It’s closer to the 0.3-0.5 range. As long as they stay not perfectly correlating, the likelihood of this diversification benefit persists.
And of course, like any investment, past performance doesn’t guarantee future trends. And there is not way to predict these things accurately no matter what anyone tells you (least of all me!). This is always true.
However, remember that we are talking about overall markets, not individual stocks. So our forecasting is a bit more stable, although far from perfect.
So what do I do with my international stocks?
You may remember from my written financial plan that my asset allocation calls for 35% overall of international stocks. Within just my stock portfolio, intentional stocks comprises about 40%.
So, I’m a bit higher and further to the right in the graph that we discussed above!
The reasons for this are:
- I am early in my investing career and can take more risk with my stocks
- My real estate investments give me passive income right now. So I can easily wait out downturns in the overall or international stock markets
- I’ve been sleeping fine so far
401k vs Real Estate: Which Is Best?
Could this change? Of course! Just like anything. But for now, I am happy investing 35% of my asset allocation in a broad international stock index fund.
What can you do?
Going with an 18% stock allocation to the international side in your portfolio is the closest to a win-win that you get with investing.
So, if you are 100% US stocks, consider adding a small percentage of international stocks…
…Or don’t! It’s up to you!
Either way, you do need to make sure that you develop your asset allocation based on your risk tolerance and select investment options that accurate reflect these decisions!
What do you think? Do you have International stock in your portfolio? How much? How did you decide on this asset allocation? Let me know in the comments below!