Is it time to invest overseas?

November 21st, 2007 at 07:50am Brent Brodeski

 Brent R. Brodeski, MBA, CPA, CFP^®, CFA, AIFA^®

Lately, foreign investing is the buzz.  After being out of favor during most of the 1990s, it is back with a storm.  Favorable valuations after the 2000-2002 bear market, globalization, a weak dollar and big growth in emerging markets has led to substantially higher foreign returns vs. those in the U.S.  Like clockwork, whenever a particular investment category does well, investors notice.  In fact, most net cash flows into stock funds in the last year have gone into foreign investments.   Renewed interest in foreign investments makes sense.  Not because they are hot lately but because they should be a key component of any investor’s long-term strategy.  Still, we think it is critical for investors to first determine their proper overall foreign allocation before diving in.   

Three theories exist to guide investors to make an optimal (reasonable) allocation to foreign stocks.  These include: 

1. Identify optimal foreign allocation based on correlations and expected returns - Assuming one defines foreign stocks to include large, small, value, and emerging, and using long-term historical data, this approach typically leads investors to invest between 25-35% of their stocks overseas.  What percent within this range really depends on what time frames one analyzes and what you expect to be the diversification benefit going forward. 
2. Determine foreign allocation based on consumption model – Americans spend approximately 80% domestically and about 20% on foreign goods.  Accordingly, if one follows the logic that they should invest with whom they do business, to match their assets (investments) with future liabilities, a 20% allocation to foreign may be optimal.   
3. Invest in alignment with global market capitalization – This method suggests that investors invest where the money is.  Said differently, approximately 47% of world market capitalization is in the
   U.S. (down from 70% a few years ago) and 53% is in foreign developed and emerging markets.  Of course, this does not recognize the fact that foreign assets also require investors to incur currency risk (while domestic investments do not). 

Our recommendation:  For many years Savant has maintained that 30% of equity exposure should be allocated to foreign.  This is not a magic number but seems reasonable in light of the above three methods of determining international exposure.  Having said this, one could easily make a case for 25-35% in foreign.  Though it would be a bit out of my comfort zone, a range between 20-40% foreign might even be justified.   

Bottom line, as global consumers, it is a no brainer to invest globally.  Just be strategic about it instead of chasing after hot returns! 

Entry Filed under: Asset Allocation, Investments