Domestic/international

Domestic/International Allocation
According to the S&P/Citibank Global Broad Market Index, as of mid-2008 about 60% of the world's stock investment opportunities, as measured by market capitalization, are outside of the United States. See Figure 1. So it makes sense to consider diversifying your portfolio by taking advantage of the large asset class of international stocks. Today, focusing solely on the U.S. means you could be missing many attractive investment opportunities.

Consider that in international markets you will find...
 * 9 of the 10	 largest metals and mining companies
 * 8 of the 10	 largest electronic equipment and instruments companies
 * 7 of the 10	 largest automobile companies
 * 7 of the 10	 largest household durables companies
 * 7 of the 10	 largest telecommunications companies

Despite the potential drawbacks of a perceived higher risk, the impact of currency fluctuations, higher investment costs, and an aversion to short-term underperformance relative to domestic markets, international stock investments provide a diversification benefit relative to an all-U.S. equity allocation.

The graph in Figure 2 shows relative investment return and volatility (standard deviation of return) for a U.S. S&P 500 index investment as well as an international EAFE (Europe, Australia, Far East) index investment. The graph shows the years from 1970 -- the first full year of the EAFE index -- to the end of 2007; a 38-year investment period. During the full period, the S&P 500 index had both a higher return and a lower standard deviation than the EAFE index. However, notice the non-linear curve of the graph. This graph shows what is known as an efficient frontier and shows that adding the diversifying effect of the EAFE portfolio (in 10% increments as denoted by the squares) to an all-U.S. S&P 500 portfolio actually increased return while also decreasing standard deviation. The 'most efficient' point being around a 70%S&P500/30% EAFE combination. But notice that adding anywhere from 1-40% EAFE resulted in an increased return with either a similar or lower standard deviation.

Of course, these returns are based on historical numbers for a nearly 40-year period. Looking at Figure 3, which shows the efficient frontier by decade, it is obvious that the optimal U.S./International allocation differs depending on the period. However, one thing is clear; combining both U.S. and International stocks has historically increased your return, decreased your volatility of returns, or both.

Figure 4 is similar to Figure 1. However, instead of using just the EAFE developed market international index, it combines that with international emerging market figures when they became available from 1988 onward. Figure 4 shows the even greater diversification effect of both developed and emerging markets stocks when added to an all-U.S. stock portfolio.

Main Types of International Funds
Some international funds select stocks from many countries, while others focus on a particular region or country. Still others select investments from countries with similar economic conditions, including the two major distinctive types of either developed markets or emerging markets.


 * A developed market exists in a country that is a fully modern industrial nation with a well-established stock market, such as most Western European nations, Canada, Japan, and Australia.
 * Emerging markets are nations evolving from an agricultural to an industrial economy or from a government-controlled economy to a free market, such as Argentina, Indonesia, Hungary, and India.

Not surprisingly, the risks are generally higher in the emerging markets, where governments and financial markets may be less certain. On the other hand, emerging markets may offer the potential for faster economic growth as well as market cycles that are less synchronized with the developed markets.

Risks of international investing
Currency risk. Investments denominated in foreign currencies decline in value for U.S. investors when the U.S. dollar rises in value against those currencies. Conversely, the investments rise in value when the U.S. dollar weakens. There have been prolonged periods when the dollar has weakened against foreign currencies and others when it has strengthened.

Country risk. Events in a specific country—such as political upheaval, financial troubles, or a natural disaster—can drive down the stock prices of companies in that country. You can reduce but not eliminate this risk by choosing an international fund that invests in many countries and has a strong focus on developed nations.

Liquidity risk. Sometimes foreign stocks can be difficult to buy or sell, in part because trading volume on foreign stock exchanges tends to be much lower than on U.S. exchanges. Liquidity risk means the fund manager may have trouble buying or selling stocks without causing their prices to rise or fall substantially. You can reduce this risk by focusing on funds that invest in many countries and on those with well-established financial markets.

Links

 * International Equity: Considerations and Recommendations (Vanguard Investment Counseling & Research)
 * Reference Library: Academic papers on International Stocks
 * Reference Library: Academic papers on US Stocks