OVER THE DECADES, the recommended allocation to foreign stocks has crept ever higher. In the 1980s, stashing 10% or 20% of a stock portfolio in international markets was considered enough. Today, most experts would consider that too little. Indeed, in the model portfolios offered in the investing chapter, 50% of the stock market money is in foreign stocks. Our contention: Investors should weight markets according to their stock market capitalization, which would mean having roughly half of your stock market money in foreign shares.
Sensible? It’s important to have some allocation to foreign stocks, because that helps reduce a portfolio’s overall volatility. But you get most of this risk reduction with the first 20% allocated to foreign stocks. Moving additional money overseas can further reduce risk, but at a diminishing rate. The implication: Those who think U.S. shares will outperform foreign stocks over the long haul, or who are uncomfortable investing overseas, might stop at a 20% allocation. Only time will tell whether that helps or hurts performance—but it shouldn’t make too much difference to your portfolio’s overall volatility.
Keep in mind, however, that risk reduction isn’t just about short-term volatility. Investors also need to be concerned about the danger that U.S. stocks have especially bad long-run performance. The upshot: If you have the bulk of your money in stocks, it’s particularly important to diversify into foreign shares—otherwise your portfolio could suffer badly if U.S. stocks generated terrible long-term returns.
As you ponder how much to invest in foreign stocks, also think about how your investment assets match up with your future liabilities. What liabilities? That’s a fancy Wall Street term for your investment goals. If you plan to retire in the U.S. and send your children to U.S. colleges, the bulk of your future spending will be in U.S. dollars. That suggests you should be leery of taking too much currency risk, especially as you approach the time when you’ll start drawing down your portfolio.
How much currency risk are you taking? Don’t just consider your stocks. Instead, think about your overall portfolio, including how it might change as you approach retirement. Over the final 20 years before you quit the workforce, you might move from 80% stocks to 50%, with the balance going into bonds—typically U.S. bonds.
Factor in those U.S. bonds, and suddenly your assets may be more closely aligned with your spending, even if your stock portfolio is heavily invested in foreign stocks. Let’s say you own 50% stocks and 50% bonds, with the bonds entirely in U.S. securities but half the stocks invested abroad. Overall, your portfolio would be 75% in U.S. dollar-denominated investments and 25% in foreign investments. Given that the bulk of your retirement money will likely be spent on U.S. goods and services, you probably wouldn’t want more than 25% invested abroad—and more conservative retirees might aim for somewhat less.
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