How much should I have allocated in international equities?
I am a long-term and active investor with a usually low risk profile. One aspect of investing I am not knowledgeable on is international equities. How do I allocate international equities in my portfolio? What are the typical risk levels for investing in these equities?
First of all, there is no such thing as a "typical" risk level. Your risk tolerance is unique. That having been said, there is generally an inverse relationship between risk and return, over time. Someone with a low risk tolerance but with a long investment time horizon may be persuaded to invest in somewhat riskier investments than another investor with a generally higher tolerance for risk, but less time to their goal.
The United States represents about 25% of world GDP and the eight largest economies (US, EU, Britain, China, Japan, India, Brazil & Canada) make up 75% of world economic activity. One way to construct an international equity portfolio would be to allocate 75% of it to these developed economies and spread the remaining 25% out over the emerging markets of the rest of the world. Emerging markets should have the potential to grow more than the developed world, but they also have a lot of risk built into their economies and currencies that could result in volatile performance in the short run. A conservative investor might want to only allocate, perhaps, 10% to the emerging markets and overweight their commitment to the developed world to the relative safety of the US.
Within the US, one could allocate to mid-cap and small-cap sectors to target growth without taking on the direct risk of investing internationally, in search of higher returns. Also, bear in mind that much of the profit realized by big US companies is the result of their business activities world-wide so even without investing in international equities, a portfolio of all big-name American companies (Think Boeing, Caterpillar, Johnson & Johnson) will already have a significant component of international exposure.
Keep in mind that there is a distinction from an international mutual fund that invests in assets around the world excluding the home country and a global mutual fund invests in assets around the world including the home country. Most financial analysts recommend putting a range of 15% to 25% of your money in foreign stocks. If you are a long term/low risk investor that would like some international exposure I would recommend a smaller allocation to an international fund.
Alternately, but with more risk, you may get some international exposure in your portfolio with American Depositary Receipt (ADR) is a certificate that represents shares of a foreign stock owned and issued by a U.S. bank. The foreign shares are usually held in custody overseas, but the certificates trade in the U.S. Through this system, a large number of foreign-based companies are actively traded on one of the three major U.S. equity markets.
ADRs give U.S. investors the ability to easily purchase shares in foreign firms, and they are typically much more convenient and cost effective for domestic investors (versus purchasing stocks in overseas markets). And because many foreign firms are involved in industries and geographical markets where U.S. multinationals don't have a presence, investors can use ADRs to help diversify their portfolios on a much more global scale.
Consulting a financial advisor in order to identify your individual risk tolerance and overall investment goals prior to investing would be advantageous.
The answer to this question depends on a variety of factors. One size definitely does not fit all. However, regardless of your risk tolerance, a well allocated and diversified investment portfolio should include international equities. I wrote an article called Diversification Isn’t Enough that you might find helpful.
Another important consideration is that international equities encompass a very broad range of investments with varying levels of risk. For example, there is a big difference between a large cap stock based in Germany than a small cap stock in Brazil. I’m not suggesting one is good and the other is bad. Instead, it is a matter of risk. The point here is that these are both “international equities,” but they can have very different risk return characteristics.
If you are an aggressive long-term investor, but sticking to a broadly diversified and well allocated portfolio, 30% international equity exposure would be the limit. If you are on the other end of the risk spectrum and very conservative, you would want to limit exposure to 5%.
Typical risks in international equities include, but aren’t limited to currency, political, and regulatory risks. This is in addition to other risks common to equities. I wrote an article called Investing Decisions And Tuning Out The Noise that can help you stay focused on what’s important and what isn’t.
Please note that this should not be considered investment advice and is only educational in nature. Please be sure to consult with your own legal, tax, or investment advisor regarding your specific situation.
Best of luck!
David N. Waldrop, CFP®
Foreign equities exhibit somewhat higher volatility than US stocks. From 2001 to 2015, the volatility of the Russell 3000 was 15%. Developed market foreign stocks had a volatility of 18%. Same ballpark.
Since the onset of the financial crisis in 2008, foreign stock performance has substantially lagged American stocks. Don't be dissuaded by results over a few years. Over the longer term, the addition of foreign stocks to an equity allocation has reduced risk while preserving overall return. Why? Overseas markets have differing economic cycles, currency movements, and industry weightings. Foreign price action can offset price movements in the US stocks and thereby reduce volatility in your portfolio.
The question is, how much foreign equity to include in your overall stock allocation. If we were to use market capitalization as a guideline, US and foreign stocks would be about equally weighted. That's because the total stock market value of the US is about 52% of all the world's stock markets. As a practical matter, most of your expenses are denominated in dollars. The US market is also more transparent that most foreign markets. That argues for an overweighting in US stocks. Empirical studies also suggest that including 20% to 40% of foreign stocks in an equity portfolio offers maximum risk reduction. If you want to dig a bit deeper, here is a recent article that I wrote on the topic.
Bottom line is that I would recommend adding diversified foreign stock index funds to your portfolio as new money becomes available until they comprise between 20% and 40% of your equity assets.
International equities are considered higher risk, especially emerging markets. In regards to long-term, your allocation would depend upon your age. The older you are, the less you would allocate overseas.
With regard to "active" investing, it depends on what type of sell discipline you have. If you have a strong sell discipline and cut your losses quickly, thus keeping them small, then you are reducing your risks. Therefore, overseas investing would theoretically carry less risk. But you have a sound discipline and follow it. Otherwise, you are just guessing.
Hope this helps, Dan Stewart CFA®