Don’t put all your eggs in one basket.
You’ve probably heard many people tell you this, from your mom to Jim Cramer to folks writing on physician personal finance blogs. That’s why the S&P 500 and U.S. total stock market index funds are the largest mutual funds in the world.
People know the importance of diversification and for good reason: it’s one of the few free lunches on Wall Street.
The problem with investing in only an S&P 500 or total stock market index fund is that while the United States may feel like the center of the universe, the international economy is very large.
In fact, half of the world’s market cap is located in companies outside the United States.
That’s why the 3-fund portfolio has become so popular. By having money in U.S. stocks, international stocks, and U.S. bonds, you have diversification in not just the U.S. economy, but the world economy.
But how much international stocks should a three-fund investor have in their portfolio? It’s not an easy question. Here’s why.
Historical Returns of U.S. vs. International Stocks
According to Portfolio Visualizer, since 1986, the U.S. stock market has gained 10% annually, while the international stock market (developed markets + emerging markets) has returned just 7% annually. But in any given year, international stocks may outperform U.S. stocks or vice versa. In fact, despite its overall under-performance, international stocks have outperformed U.S. stocks in 15 of the past 32 years.
The Case For International Stocks
Using historical returns of the S&P 500 and EAFE index, you can build an efficient frontier of various asset allocations between U.S. and international stocks. Over the time period 1970-2008, it turns out that an 80% U.S. / 20% international portfolio had a higher return, with lower risk, than a 100% U.S. / 0% international portfolio.
Over this same time period, the asset allocation with the maximum return was a 50% / 50% U.S. / international portfolio.
Remember that these returns are achieved even though international underperformed domestic stocks over this time period: a 100% international / 0% U.S. portfolio had the lowest return and the highest risk. That’s the power of diversification: because the U.S. and international stock markets do not move in lockstep with each other, you can improve your returns and reduce your risk by adding international stocks.
Of course, past performance is not indicative of future returns. You should not try to optimize your portfolio based on an efficient frontier built on past returns. For example, according to a Bogleheads analysis, the optimal portfolio of U.S. / international asset allocation has varied depending on the decade you are studying. The optimal portfolio in the 1970s was 70% domestic / 30% international, while in the 2000s, it was 100% domestic / 0% international.
The Case Against International Stocks
International stocks are more expensive to own than U.S. Stocks
International stocks have slightly higher expense ratios than U.S. index funds, but the difference is typically only a few basis points (a basis point is equal to 0.01%, or $1 per $10,000 invested). For example, Vanguard’s Total International Stock Index Fund (VTIAX) has an expense ratio of 0.11%, while their Total Stock Market Index Fund (VTSAX) and S&P 500 Index Fund (VFIAX) each have expense ratios of 0.04%. So the difference in fees on a $1 million portfolio is $700.
International stocks are less tax-efficient than U.S. stocks
International stock funds are less tax-efficient that U.S. stock funds. Some of this has to do with the higher dividend yield of international index funds, and some has to do with the inefficiencies of managing a portfolio invested in the less-liquid international stock markets. For example, over the past 5 years, the amount of returns lost to taxes (before even selling the index fund) for the Vanguard International Index Fund VTIAX was 1.19%, while only 0.48% was lost in taxes with VTSAX (Vanguard Total Stock Market Index Fund).
Of course, you do get some tax benefits with international stock funds, such as the foreign tax credit. And by placing international stocks in a tax-deferred or retirement account, you are not hurt by international’s relative tax inefficiency.
International Stock Asset Allocation: Three Different Approaches
No International Stocks
Warren Buffett does not recommend international stocks to ordinary investors. He has previously recommended us to “Buy American.” In his 2013 annual letter to shareholders, he suggested a portfolio of 90% S&P 500 and 10% short-term government bonds to investors.
Of course, many of his holdings — such as Apple, Coca-Cola, and Proctor and Gamble — do significant business overseas. So many of the factors that influence the movements of international stocks — currency markets, European macroeconomics, and global unrest — affect the prices of his U.S. based holdings as well.
Jack Bogle also recommends against international stocks in his portfolio. His rationale is a global macroeconomics argument. He has a firm belief that the U.S. economy will continue to outperform the global economy in the future. For example, in an interview with Morningstar’s Christine Benz, Bogle argued that each of the major countries in the EAFE international index have significant economic headwinds. Compared to Europe’s and the rest of the global economy, the U.S. economy looks pretty good in Bogle’s eyes.
Market-Weight International Stocks
Another approach would be to have a market-weight allocation of international stocks. Since only half of the world’s market cap is in U.S. based stocks, that would mean that a market-weight asset allocation would be 50% U.S. / 50% international stocks.
This is the purest way to own the global (U.S. + international) stock market. Any other allocation would be overweight or underweight international stocks.
Over-Weight International Stocks
A small minority of investors believe you should be over-weight international stocks. These people would have a bearish view on the U.S. economy. They believe that international stocks will outperform U.S. stocks in the future and a portfolio overweight in international stocks would outperform a more balanced portfolio.
These people also might argue that you should not put 50% or more of your portfolio in a single economy, even if it is the largest, greatest economy in the world. Some people point to the example of Japan, which peaked in 1989 and has had negative 30-year returns. It would not be good if the U.S., as great as it is now, were to have Japan-like returns in the future.
My Personal International Stock Allocation
I see the diversification benefit in international exposure, but am not comfortable with a fully market-weight international stock allocation. My stock allocation is 2/3 domestic, 1/3 international. This happens to be between the international allocation of Fidelity’s target-date funds, which are 70% domestic, 30% international, and Vanguard’s target date funds, which are roughly 60-40. Based on historical data, this allocation would lead to the lowest risk portfolio, but I am not expecting future stock returns to align with its past performance.
Whatever asset allocation you pick, stick with it. The worst-case scenario is to increase your international allocation when international stocks are doing well (e.g. in 2017), and reduce your overseas exposure when the U.S. is outperforming. Because there are so many good arguments for any international allocation, it’s easy to cherry-pick your allocation based on what’s popular at the time.
What do you think? What is the international stock allocation of your portfolio?