Diversifying stock exposure internationally is a free lunch, so eat lots of it.
Today concludes our discussion on international stocks and whether investors should consider them in their portfolios. Negative tracking error has resulted in my receiving an increasing amount of calls questioning the wisdom of investing in international stocks.
To help you avoid making the mistake of recency, here are two questions to ask yourself:
First: While the economic news from the developed and emerging markets has been concerning, am I the only one aware of the news? If I’m not, which is surely the case, the negative news must already be embedded in prices. That’s why international stocks have done relatively poorly. It doesn’t tell me what they will do in the future.
Second: Do I really want to sell now at a time when international stocks are selling at discounts relative to U.S. stock—that is, they have lower price-to-earnings ratios multiples—and thus international stocks have higher expected returns?
For example, according to Morningstar, as of April 30, 2014 (most recent data available) the P/E ratio of the Vanguard S&P 500 ETF (VOO | A-96) was 16.7, and its book-to-market ratio (BtM) was 2.3. The P/E for the Vanguard FTSE All-World ex-US ETF (VEU | B-97) was just 14.4 and the BtM was just 1.4. And the Vanguard FTSE Emerging Markets ETF (VWO | C-90) had a P/E of just 11.4 and a BtM of 1.4.
The significantly lower valuations of the stocks in the two international indices indicate that while their economic risks might be greater, the market has priced in those risks, so they have higher expected returns as compensation.
With the facts and behavioral issues in mind, let’s examine why you might consider a higher or lower international allocations.
The following is from my book, “The Only Guide You’ll Ever Need for the Right Financial Plan.”
Reasons to Increase International Equity Exposure
- Reduced Risk: The historical evidence suggests that raising the international allocation to at least 40 percent reduces portfolio risk (volatility). For investors who have a substantial risk to the value of their labor capital, an allocation of 50 percent or perhaps even a bit higher may be appropriate.
- Investor Has Non-U.S. Dollar Expenses: An investor may live part of the year overseas, or frequently travel overseas. The investor should consider tailoring the portfolio to gain specific exposure to the currency in which the expenses are incurred. This could also be accomplished by making fixed-income investments in the local currency.