Investors have been told for years that they should put a portion of their money into foreign stocks as a way of balancing the U.S. market. The theory behind that advice was: When U.S. stocks zig, those foreign stocks zag.
But in recent weeks sell-offs have roiled foreign markets along with domestic stocks. Advisers have warned that some other markets (such as Asian stocks, up more than 60 percent this year) are riding for a fall. And those rolling sell-offs mean that the zig zag theory of buying foreign stocks means less than it used to: If U.S. and foreign stocks are more aligned than they used to be, why bother holding foreign shares?
Financial advisers are starting to ignore the diversification argument for foreign stocks and instead pushing their out-sized gains. And some of those gains are definitely out-sized. In the last year, mutual funds holding large U.S. stocks returned between 12 and 14 percent, on average. Funds which focused on comparable Latin American and Asian stocks reported returns topping 50 percent and even European stock funds -- said to most closely resemble U.S. markets -- topped 21 percent returns, according to Morningstar.
Of course, that might make it absolutely the worst time to start buying foreign funds, if you haven't already. Investment theory suggests that shareholders should periodically rebalance their portfolios, buying shares that have been beaten down and selling shares that have blown up in proportion to the rest of the portfolio. So folks who were on the foreign stock bandwagon early, with large investments, might want to trim some of those funds now. But they are a minority. Most U.S. investors have been so low on foreign stocks that they might be in better shape now that foreign stocks have risen so quickly. Or they still might want to buy more.
Here is some guidance on what to do now about foreign stocks.
- Consider reserving as much as a third of your portfolio for foreign stocks. That's the recommendation of Ibbotson Associates and also of Morningstar analyst Chris Davis, who calls that 33 percent figure A useful starting point. The rationale behind it is: U.S. companies make up only 45 percent of the world's economy, but investors who therefore aim to keep 55 percent of their money in foreign stocks aren't accounting for the fact that many U.S. companies already are diversified internationally. Furthermore, U.S. investors put away money so they can later spend it in the U.S.; therefore it makes sense to have a bit of extra money invested in domestic stocks that will presumably move in tandem with the U.S. economy, suggests Davis.
- Consider index funds and exchange traded funds for the heart of your international allocation. They will keep you broadly diversified and keep fees and costs to a minimum. The American Association of Individual Investors recently added foreign funds to its model exchange traded fund portfolio, recommending these four funds: SDPR S&P International Small Cap (GWX), which focuses on small stocks from developed countries; Vanguard FTSE All-World Ex-U.S. (VEU), which is weighted towards large companies, but includes 47 countries and could be a no-brainer if you only want one fund to stand in for your total foreign holdings; SDPR DJ Wilshire International Real Estate (RWX), and Vanguard Emerging Markets (VWO).
- Don't make big bets on little spots. Don't buy single country funds unless you've taken care of the basics and investing is your hobby. Be reluctant to buy small regional funds too: These categories could be unnecessarily risky.
- Know what you are buying. Don't just look at returns, look at the policies of the funds you are considering. Do they hedge currencies, or might most of their recent gains have been the result of the dropping dollar? Do they extract unreasonably high fees because they are scouring the world for stocks? If you're paying extra for an actively managed fund, instead of an index fund, does the manager have on the ground expertise for the regions where he is stock shopping? Does the fund have ways to interpret foreign financial statements, which may not be written to U.S. standards? Does it weed out politically problematic countries?
- Today stocks, tomorrow bonds. Foreign firms and governments tend to pay fat interest rates on the money they borrow, too. So after you've gotten the stocks side of your portfolio properly diversified, start learning about, and investing in, foreign bond funds for a portion of the income side of your portfolio.