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International Allocation: Maximum and Minimum

What percentage of the stock portion of your portfolio should be invested internationally? Vanguard’s website (in a section only accessible if you’re logged in) contains this statement:

“Investing up to 20% of your stock portfolio in international stocks can help you diversify. Between 20% and 40%, your diversification improves, but at a lower rate. And because of the risks of international investing, an upper limit of 40% is wise.”

20-40%. That’s more or less in keeping with conventional wisdom.

But conventional wisdom seems to gloss over something here: Having 80% of your portfolio (more than 80% if we assume that the entire bond portion is invested in U.S. bonds) invested in one country is not diversified–especially for anybody whose income is largely dependent upon the U.S. economy.

Past and Future

I assume Vanguard’s statement is based on an analysis of historical returns. I can only guess which exact period(s) they’re looking at, but surely it’s limited to the 20th century plus the first decade of this century–a period during which the United States went from being a young upstart nation to being the world’s largest economic superpower.

It’s hardly a surprise that based on an analysis of that period, a U.S.-heavy portfolio looks pretty darned good. What I’m not so sure we can expect is for the next 10, 20, 30, or 60 years to look the same.

Starting Point: Market-Weighted Portfolio

To me, it seems that the starting point for discussion should be a market-weighted portfolio. At the moment, such a portfolio would be invested approximately 40% in the U.S. and 60% internationally.

From there, you can make adjustments to cater to your specific needs. For example, if you’re in (or close to) retirement, it could makes sense to decrease your international allocation for two reasons:

  • First, you’re going to be spending down your investments soon, which means that it would be good to minimize currency risk (the risk caused by fluctuations in exchange rates that comes with owning non-U.S. investments).
  • Second, you have fewer years remaining in the workforce, meaning that you’re less dependent upon the U.S. economy that somebody who is, say, 25 or 30.

Alternatively, if you’re in your 20s or early 30s, it could make sense to increase your international allocation relative to a market-weighted portfolio for precisely the opposite reasons.

Avoiding the “Growth Trap”

What I’d caution against, however, is falling into the growth trap–overweighting emerging markets (China or India, for instance) simply because you know they’re going to grow at a faster rate than the U.S. over the next couple decades.

When it’s obvious that a country’s economy will be growing quickly, that growth should already be reflected in the price of their stocks. To earn above-market returns, you need to invest not in countries (or companies) that grow quickly, but in countries (or companies) that grow more quickly than expected.

If you’re going to invest more of your portfolio in non-U.S. investments than conventional wisdom would suggest, do it with the goal of diversification, not with the goal of earning superstar returns.

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Comments

  1. Nice job covering this issue, Mike. You already know I agree with you on this, so I don’t have much to add. I just thought you presented it clearly and succinctly. I think I shouldn’t write anything on investing and just send my readers over here! 🙂

  2. I don’t advocate over 20% of equity going international. I realize that the portfolio won’t match the world market, but that’s usually not the objective. The objective is often to hold a portfolio that, when combined with appropriate regular cash flow additions, and creates the most reasonable likelihood of satisfying defined, personal priorities. 10% to 15% international typically does this.

    Too much international can potentially work against this objective because international equities carry additional uncertainty. If you are in the US, saving US dollars, basing goals on US dollars, and planning to later spend US dollars, your probability of successfully funding those goals is sensitive to increases and decreases in international equity allocations.

    A major reason for overweighting US markets relative to the world has to do with how you plan to balance risk through asset allocation. If you choose to use government bonds, US Treasury issues and/or index investments are readily available and affordable, and they appropriately balance risks of US equities. If you invest heavily in international markets and want to preserve that same treasury:equity risk:return relationship, you must then buy international treasuries. This not only adds additional uncertainties for US based investors, but it can also be much more expensive (even if you like credit risk, you’ll face similar obstacles outside the US). In other words, slightly increasing US stocks and decreasing US treasuries may yield a better risk adjusted return than increasing international within equity and bond allocations (or even just equities).

    The bottom line becomes a question of how much of the additional risk, uncertainty, and expenses associated with international investing can still work in your favor. I think this is a more important consideration than aiming to match the world equity market.

  3. I have about 10% of my Vanguard IRA in the Total International Fund. This appears to be a fund of funds comprising the European, Pacific, and Emerging Markets funds. What I don’t understand is that in their target retirement funds, Vanguard includes each of these three funds individually rather than having all its international in the Total fund. A friend suggested having those three funds rather than the Total would give me more flexibility in re-balancing, but I don’t know if that matters so much and it doesn’t explain Vanguard’s approach in the target funds. Any comments?

  4. Larry: Good question. I’m not sure why Vanguards target funds use those three funds rather than one of their more encompassing international funds to tell you the truth.

    As to doing it on your own, using the three separate funds does give more opportunity for a rebalancing bonus. At the same time, it definitely increases complexity (and expenses, if you’re using ETFs rather than open end index funds). In my own portfolio, I don’t separate out the non-US funds like that.

  5. I appreciate the need for diversification and additionally why you would want to look towards international investment opportunities. But are the lines between international and U.S. equities getting blurred these days of globalization?

    In 2006 44% of the S&P 500’s revenues came from overseas. If you have a basket of U.S. funds that are representative of the market and then add a 20% to 40% basket of international funds would you then have too much exposure to international funds?

  6. Dylan, you’re right that beyond a certain point, adding further to one’s international stock allocation hasn’t historically provided much benefit. The reason, as I understand it, is that US and non-US developed markets are highly correlated.

    What I’m concerned about is the possibility that that correlation falls off a cliff at some point.

    I know that in order to protect against that possibility, I’m taking on other risk (currency risk, for instance) as well as a very real possibility that my portfolio may underperform a more US-heavy portfolio over any given period (including the period that is my lifetime).

  7. LeanLifeCoach, from the data I’ve seen, as much as globalization is talked about, it hasn’t lead to a noticeable increase in correlation between markets around the world. (At least according to Siegel’s Stocks for the Long Run and Bernstein’s The Intelligent Asset Allocator.)

  8. Mike, I’m not sure I would say US and non-US developed markets are “highly” correlated. Correlation differences are a good reason to have some international exposure. But the limitations I see are not about correlations between US and international equity markets, but instead have to do with the correlations between international equities and a lower-correlated counter-asset like bonds. There is an economic relationship between the US stock market and the US bond market, particularly treasures, that does not exist between international stock markets and the US bond market, at least not to the same degree.

    The amount of international exposure question is less about investment return and more about investor return. Those other risks can contribute to the disconnect between a higher average return and actually having more money. So it’s not even so much about historical correlations or returns; its more about international market returns having greater standard deviations, bad-timing risk, and limitations on mitigating those cost effectively through asset allocation.

  9. A few months ago, I compared the asset allocation recommendations at the major brokerages. There is a huge difference between what each of them considers to be a “conservative” portfolio. They also report significantly different expected returns for each portfolio type — and the difference cannot be accounted for by the different weightings. The primarily difference is that they look back over different time periods.

    http://www.scienceandmoney.com/2009/07/29/comparing-asset-allocation-schwab-vs-morningstar-vs-fidelity/

  10. Just read this from archives..:) and…

    I just cant seem to decide between FDIVX and VGTSX for my 401k… the former has higher .77 ER and 54 % turnover, the latter has .32 ER and 12 % turnover. both seem to be in the same category of largeblend. Although I dont solely want to base it on past performance in which FDIVX did better, but the ER and T.Over for VGTSX is better compared to FDVIX.

    Any one had ever come across this dilemma before? I am leaning towards atleast 35-40 % of allocation for intn’l funds for my portfolio.

  11. Within a given category, I’ll choose a low-cost index fund over a higher-cost active fund every time. Historically, expense ratio has been shown to be a far better predictor of future performance than past performance has.

    Of course “better predictor” doesn’t mean “always right.”

  12. Thanks for the insight. Appreciate it Mike.

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