I was browsing CNN Money recently and came across this Money Makeover piece.  For those of you who don’t know, Money Makeover is a series CNN Money runs where they overhaul a reader’s portfolio and give advice about their financial situation.  Enter TeRon Lawrence, a self-described aggressive investor who had allocated approximately 49% of his portfolio to international stocks.  While 49% may seem a high international stock allocation, it’s still less than what it would be in a global market-cap-weighted portfolio.  Unfortunately, Money magazine contributing writer Yuval Rosenberg thinks that’s too risky.  Is he correct?

Is International Investing Riskier?

As in all things, it depends on how you look at it.  According to a 2006 study by Gary Burtless from the Brookings Institute, “Pathways to a secure retirement,” allocating substantial portions of your portfolio to foreign stocks and bonds is a double-edged sword.  From the study,

“The results show that workers can substantially increase their expected pensions if they include foreign equities in their pension portfolios…however, increasing workers’ allocation to overseas assets will not reduce the risk of catastrophically poor investment performance…tabulations show that the risk of obtaining a very low pension replacement rate actually increases if workers allocate a sizable part of their savings to overseas investments.”

In other words, in good times a healthy allocation to foreign equities can be a boon to investors, growing their retirement accounts and eventual retirement incomes substantially over what they could have achieved with just US equities.  International investing does not seem to reduce the likelihood of painful losses when times are trying, however.  The famous axiom “diversification fails us just when we need it most” seems to ring true, or has in the past.

So Wait, International Investing Doesn’t Work?

Not quite.  The above conclusion is based on mathematical calculations on volatility, but that doesn’t tell the whole story.  When viewing risk through a more reasonable lens of avoiding permanent loss, a large international allocation is thoroughly justified. 

First, Burtless study examines only the past, not the future.  The period 1926-2006 was a golden era of American economic hegemony so it comes to no surprise that American markets would exhibit above-average performance over the study period.  In fact, US home-country returns ranked second behind only Australia for overall performance, and that just barely.  But that’s not guaranteed to last forever.  In fact, many would argue the US has already begun its long, steady economic decline relative to the rest of the world.  Thus, this study is really just a case of declaring what everybody already knew:  the US experienced an economic miracle in the 20th century.  Looking forward, however, it seems as though China and India will be the economic miracles of the 21st century, not the US.  If that is the case, the justification of home-country bias for US investors is significantly weakened.  Past performance is no guarantee of future results.

Second, Burtless doesn’t take emerging markets into account, which can be a powerful diversifier.  In fact, he doesn’t take real estate, commodities, or any other asset class into consideration either, making the study something of a red herring.  The essence of modern portfolio theory is to combine many non-correlated asset classes into a single portfolio, not just one or two moderately non-correlated asset classes, such as foreign and domestic stocks.  In the real world, a prudent portfolio would include at least one or two additional asset classes, completely and totally changing all possible outcomes.  Thus, while the conclusion of this study that foreign equities do not provide an overall positive benefit to retirement incomes may be true in a fake world where only two or three asset classes exist, it doesn’t apply at all to a prudent, real-world portfolio.  I plan on maintaining my 40% international allocation going forward.

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