Asset Allocation in Action–Domestic vs. International Mutual Funds

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This has been a hot topic as of late. How much should one invest in international or foreign stocks? Let me first say that the question, as phrased, is a touch on the arrogant side. We Americans just assume that everybody knows that by domestic we mean U.S. stocks. I guess everybody does understand that, but U.S. versus non-U.S. may be a clearer way to state the question.

As a starting point, about 50% of the global market capitalization is in U.S. companies. The significance of this fact, to me, is that about 50% of the global market capitalization is NOT in U.S. companies. If one is looking to mirror the market, 50% of the stock portion of a portfolio should be invested in foreign funds. Given that about 50% of the world’s market cap is outside the U.S., it’s interesting to note that many financial advisers suggest a portfolio comprised of significiantly less than 50% in foreign funds. In his book The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk, Bernstein recommends portfolios with as little as 15% in foreign funds. The Bogleheads in The Bogleheads’ Guide to Investingrecommend portfolios with just 10% allocated to international funds.

Why is this? Risk. Non-U.S. investments are often viewed as carrying more risk than U.S. investments. Using standard deviation as a measure of risk, it does appear that international funds are riskier than U.S. funds. Using two well known indexes as examples, the Vanguard Total Stock Market Index (VTSMX) has a standard deviation of 7.94% according to Morningstar, while Vangaurd’s Total International Stock Index fund (VGTSX) sports a standard deviation of 9.73%.

Ok, so how much should one invest in international funds? Like any aspect of asset allocation, there is no one right answer. Many recommend allocations of no more than 35%, and as noted above, many recommend much less. Because international funds tend to carry more risk, many suggest reducing your exposure as you near retirement.

My Approach

I allocate about 35% to international funds, which includes not only stock funds but also a portion of my REIT funds and my bond funds. Here are the international funds I own, followed by the percentage of my total portfolio each represents:

• Vanguard Emerging Markets Stock Index (VEIEX)(12.5%)
• Vanguard International Explorer (VINEX)(11%)
• Fidelity Diversified International (FDIVX)(8.5%)
• Templeton Global Bond (TPINX)(1.8%)
• Fidelity International Real Estate (FIREX)(1.8%)

Again, I’m not suggesting any of these funds or the allocation is right for you. We each need to make our own investing decisions. But these are the choices I’ve made.

One final thought. It’s my view that the U.S. dominance in financial markets will gradually wane. This isn’t a brilliant thought on my part, many have the same view. Just read Friedman’s The World Is Flat [Updated and Expanded]: A Brief History of the Twenty-first Century to get an idea of how globalization is changing everything. The point is that I believe international investments will provide an excellent opportunity for growth over the next few decades that U.S. investments will not. Am I right? I’ll let you know in 20 or 30 years.

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