August 9, 2014

International Stocks: How Much of Your Portfolio Should be Invested Abroad?

According to Forbes, retail investors are scared of foreign stocks. Maybe it's because international stocks speak with accents or in a language you can't even understand? In fact, the article cites a NASDAQ OMX survey that found just around a third of investors own stocks outside of the U.S. and a major reason for that is, "lack of knowledge about international investing opportunities."

That's crazy when you consider 51% of the global equity market is made up of companies based outside of the U.S, according to Vanguard Research. The same study concludes that allocating 30% of your equity holdings to non-U.S. stocks provided the most diversification benefit.

Historical dude thinking about international investingOther experts tend to recommend anywhere from 10% to 50%. Many don't seem to have much rationale for their recommendation other than gut instinct.

These guys are probably more smarter than me, but I tend to prefer a 50% allocation to international equities. I figure in the long-run that will smooth out fluctuations in the dollar and it's amazing how closely U.S. stocks tend to track those abroad.

MSCI Index Performance data is an awesome resource. Comparing the MSCI North America Index (yea, there's nearly 7.5% Canadian stocks in this index, but I figure it's probably tracks the S&P 500 pretty closely) going back to December 1969 to the EAFE (Europe, Australasia and the Far East) over the same time period, we see pretty similar performance. Both are gross returns, including dividends.

MSCI North America Index vs the EAFE: Long-Term historical chart and total returns

The ride was a bit choppier for the EAFE, but both indexes tend to trade stretches of out-performance. It's difficult to see in the chart above, but identical investments in both indexes in 1969 would have resulted in the EAFE position being worth well over twice that of the North America position by the mid-80s. By 1997, international stocks fell behind again, taking the lead once more in 2005, crushing North American equities for the next couple of years until the crash.

During the current bull run, North American stocks have handily surpassed the performance of the EAFE index, but let me reiterate: both indexes ended up in the same place over the course of roughly 36 years, from 1969 to 2005.

Based on this extended historical pattern, a 50/50 split between U.S. and international stocks makes the most sense to me. For large/mid-cap international exposure there are tons of great ETF options available:
  • EFA - Tracks the EAFE index, by far the biggest international ETF based on assets (over $53 billion!) and a reasonable 0.34% expense ratio.
  • VEA - Vanguard's ETF based on the FTSE Developed ex North America Index (performance is virtually identical to the EAFE index). This ETF sports a 0.09% expense ratio!!!
  • VEU - Basically VEA but with 18% of its portfolio invested in Emerging Markets (0.15% expense ratio).
  • SCHF - Schwab's ETF that also tracks the FTSE Developed ex U.S. Index, but with an even smaller 0.08% expense ratio (although 0.01% compared to VEA is splitting hairs).
  • ACWI (0.34% ER) and VT (0.18% ER) - Both ETFs track total world stock indexes. An investor wanting to track the global equity markets could theoretically own just one set-it-and-forget-it ETF, and these two would be your choices. Vanguard's Total World Stock ETF holds just under 50% of its portfolio in U.S. stocks and the rest abroad - all for a 0.18% expense ratio.


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