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Personal Finance

Getting Rewards Without Risk - Invest Internationally

By John Arnopp
401k Forum Analyst

The World Is Your Oyster

Over 50% of the world's equity rests outside of the United States. This is too large a market for a clever investor to ignore - especially since foreign investments, when combined with U.S. stocks, offer additional profit potential while reducing total portfolio risk.

While international stocks are "foreign" to us, the factors affecting them are largely the same as those affecting U.S. stocks: earnings, interest rates, and the outlook for inflation and the home economy. Still, international investing involves additional uncertainties that you wouldn't necessarily have to worry about with a U.S. stock, such as the country's political stability, its financial reporting standards (which might be less stringent than in the U.S.), and currency/exchange rate risk.

So why invest outside the U.S., given these additional unknowns? Diversification. In fact, if you invest broadly across the international spectrum, these unknowns will actually melt away as the various risks and currency fluctuations cancel each other out, thereby reducing risks and actually increasing overall long-term returns.

Consider that in the past 30 years there have been eight bear markets in the U.S. (defined as a decline of at least 10%), the most recent being in July/August 1998. During every one of these, international stocks* either went up or declined by less than the U.S. market. In one of those bear markets (January 1977 through February 1978), international stocks* gained 14% while U.S. stocks lost 22%.

But Aren't Foreign Stocks Risky?

U.S. investors often fear that foreign markets are more "risky" than their home market. This is generally true when currency risk - the risk of losing money when gains and losses are exchanged from foreign currencies into U.S. dollars - is factored into a portfolio's returns. (Currency risk is discussed below.) Even without currency risk, international investing on its own is slightly riskier than investing solely in the U.S., due to the variety of political and economic events abroad. But adding these assets to your portfolio will actually reduce your overall risk as long as the "correlation" (the degree of similarity in movement between two assets) between the U.S. and foreign assets is low.

Here's an example to illustrate the benefit of low correlation. Consider the proverb at the top of this article. If all of your chickens are likely to lay bad eggs in summer, but good eggs the rest of the year, what can you do to have a steady supply year-round? It would pay to add chickens that are likely to lay good eggs in summer and bad eggs the rest of the year, even though taken by themselves they seem "riskier" because they lay fewer good eggs overall. While you would not want to limit yourself to chickens that lay good eggs only one-quarter of the time, by using them to supplement your existing chickens you are better off, because your egg supply (and income) won't fluctuate as much.

The egg output quality of the two different chickens in the example above is not similar. The two kinds of chickens show low "correlation" with each other. In the same way, adding stocks or mutual funds with low correlation to the existing stocks in your portfolio reduces the overall risk of the portfolio.

Indeed, your return on an international investment will be equal to the average of the returns in all the countries you are invested in, but the risk will actually be lower than the average for all the returns (it has a correlation slightly less than one).

Currency Risk

With international stocks, you also need to think about exchange rates and determine whether, in fact, the exchange rate risk (currency risk) is greater than the return benefit.

In the short term, unfavorable exchange rates can completely wipe out the returns from an international investment, while favorable rates can add to, or even make up the entire return on an investment. But over the long term, exchange rate risk will have little effect on the total portfolio risk. This is because, on a global level, different currencies offset one another's effects. If assets are removed from one country, by definition they must go to another country, so as one currency rises, another will fall. Thus, fluctuation will be smoothed out in a well-diversified international portfolio.

Furthermore, the amount of currency risk in a mostly domestic portfolio with only 5% international holdings would be insignificant, and it would still be very low even if 20% of the portfolio were internationally invested. As a general rule of thumb, investors should strongly consider allocating 20-25% of their total equity investments into a diversified portfolio of international stocks.

Risk Isn't Everything, - or Show Me the Money

If reducing your risk were your only goal, you would put most of your money in Treasury Bills or an insured savings account. This would indeed reduce risk, but your returns would also suffer. With international investing you can lower your risk but have more chance of earning higher returns.

There is evidence to support the contention that over the long term, domestic and foreign equity returns will be similar. FIGURE 1 compares the returns of the U.S. equity market (as defined by the Standard & Poor's 500 Index) with the international market (as defined by the Morgan Stanley Capital International's EAFE [Europe, Australasia, Far East] Index). This graph illustrates the similarity of total returns of both over the long run, in this case 25 years. The EAFE returned 13.43% per year vs. the S&P 500's 14.93% average annual return. The graph also shows the low similarity (correlation) of returns at any given point.

FIGURE 2 illustrates the diversification benefits of international investing during each of the 5-year periods from 1974 through 1998. An investor holding both U.S. and international stocks could expect to see less volatility in each period than an investor holding only one or the other asset class.

What About Other Types of Diversification?

You may ask if taking on the additional time and expense of international diversification is worth it. Perhaps you are wondering whether you should further diversify your domestic holdings instead. The answer is, you should do both.

The S&P 500 is a good proxy for U.S. equities, but it is not the only game in town and it does not represent the entire U.S. market - it is skewed toward larger companies.

But even diversifying into other broad areas of the domestic stock market, such as small-cap stocks, will not provide the full diversification benefits that investing abroad would add.

FIGURE 3 shows the correlation to the S&P 500 Index of both the EAFE International Index and the Russell 2000รข Index of U.S. small-cap stocks, for rolling 3-year time periods. A correlation of 1 would indicate identical returns, so the closer the number is to zero, the more diversification exists. Looking at a 25-year time period, the EAFE has provided an investor with more diversification away from the S&P 500 than a broad U.S. small-cap index has.

Final Thoughts

Even so, it should be noted that "diversifying away risk" isn't without its own (usually short-term) risks. Consider the case of a Japanese investor over the past two decades. During the 1980s, international diversification would have lowered his total return because the world market index and the U.S. market did not perform as well as the Japanese stock market during that period. While the Japanese investor would have benefited from the reduced risk of a global portfolio, he would not have benefited from increased returns.

However, during the 1990s the Japanese market has severely lagged behind both the world index and the U.S. market. A global portfolio during this period would surely have given the Japanese investor both reduced risk and higher returns.

Recently, the U.S. market has outperformed the world market index, but if history is any lesson, adding international diversification to your portfolio will prove to be a sound strategy for the long run.

*(as defined by the Morgan Stanley Capital International's EAFE [Europe, Australasia, Far East] Index)

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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