What’s The Ideal International Allocation?

Little more than a decade ago, most investment experts advocated keeping the vast majority of your money invested in the U.S.  During the go-go tech economy of the 90’s, large-cap U.S. stocks were all the rage while their foreign counterparts, especially those from Japan, earned comparatively low returns.  In those days, practically nobody was recommending you allocate more than 20% of your equity allocation to foreign stocks.

Times Have Changed

Due in large part to foreign stocks’ superior returns over the last decade, international investing has never been more in vogue.  Where 20% used to be the maximum recommended foreign allocation, many financial experts are now using 20% as a minimum.  While this change of heart is almost certainly due to a certain amount of performance chasing, there’s a lot of solid research backing up this shift in favor of international equities.  Over the period 1970-2007, it appears as though a 60/40 U.S./Foreign allocation has produced the ideal combination of lower risk and higher return, providing an annual return of 11.45% over the period compared to the 11.17% you would have gotten with the more traditional 80/20 portfolio.  While it may not seem like much, that extra 0.28% adds up over the years.

Some argue markets have become more correlated over the years as globalization brings us closer together, diminishing the need for international investing.  While this hypothesis makes intuitive sense, there’s little empirical evidence of it.  Correlations between markets shift constantly:  just because they happen to be correlated this year doesn’t mean they will next year, or 7 years from now.  Even if we assume this to be true, however, there’s still one huge argument for international investing:  currency diversification.  The owner of foreign stocks will actually benefit by the falling dollar.  Since currency movements are expected to more or less equalize over long periods of time, holding significant portions of foreign currency-denominated investments should dampen volatility.

How Much Is Enough?

That’s the $64,000 question.  Theoretically, a 20% allocation would be the minimum necessary to achieve significant diversification benefits while a good theoretical upper bound would be 58%, which is the percentage of global market capitalization represented by all stocks outside the U.S.  So which do you choose?  I say whatever makes you comfortable.  If allocating more than 20% of your portfolio to international equities keeps you up at night, allocate no more than 20% of your portfolio to them.  If you can stomach putting 50+% in foreign equities, by all means do so.  It’s impossible to predict what exact allocation will be optimal over the next few decades, but it’s a fairly safe bet any allocation along the continuum between the suggested min and max will do better than an all-American portfolio.