Diversify Globally for Big Stock Gains

In the third quarter of 2005, theDow Jones World Index, whichexcludes the United States, rose11.1% while the US Dow JonesIndustrial Average gained 2.9%.Among individual countries, Brazil wasup 34.7%, India 20%, Japan and Canadaeach 17.6%, and Chile 17.2%. Almostevery foreign stock market did betterthan the US market—even Germanyand France, with all their problems,gained 9.7% and 9%, respectively.

Is there a lesson here? There certainlyis, and not just one, but two.The first lesson is that diversificationpays, and to be properly diversified,you have to be somewhat adventurousand spread out some of yourinvestments around the world.

Second, neither you nor any expertis going to be consistently right aboutwhich countries are going to be thenext big earners. Why waste time andmoney chasing last quarter's winners,investing in countries like India andChina, whose economies are alreadybooming? Just as the stock of a goodcompany may be overinflated, countrieswith flourishing economies maynot offer the best buy because theirstock is probably overvalued.

Reducing Your Risk

You will often hear the argumentthat apart from providing higherreturns, international diversificationwill also reduce the risk of your portfolio,even though individual stocksfrom some developing countries canbe very risky. This is a key componentof portfolio theory.

I am a little skeptical about this risk-reductionargument, though. There islittle doubt that sometimes internationaldiversification will reduce therisk of your portfolio, as measured byvolatility. However, if the UnitedStates experiences a deep bear market,stock markets around the worldwill most likely go down as well,because the world economies havenow become closely interconnected.Only time will tell. While I amstrongly in favor of internationaldiversification, international diversificationis no panacea.

Foreign Allocations

How much of your money shouldyou invest internationally? Anywherefrom 10% to 50% of the stock portionof your portfolio is a reasonable targetfor most investors. The endowments ofboth Harvard and Yale universities,which have earned spectacular returnsover the years, have close to half theirstocks in international investments.

As with any investment, you shouldinvest only the amount you are comfortablewith because you do not wantto panic and sell when the markets godown. Because we know so little aboutwhat is going on in foreign lands, we aremore likely to panic about our foreigninvestments when the bad times hit.

Hedged or Unhedged?

Keep in mind that internationalstocks trade in their country's currency.If you invest in a stock index fund inJapan and it goes up 15%, you will havethe same gain only if the yen-dollarexchange rate remains unchanged. But ifin the same period the yen loses 15% ofits value against the dollar, then your netgain expressed in dollars will be zero.

It is possible to hedge this currencyrisk at a modest cost, and many mutualfunds of foreign stocks do. On theother hand, many other mutual fundsof foreign stocks do not hedge the currencyrisk because they argue that partof the reason you invest in foreignstocks is to protect yourself against therisk of a falling dollar.

low-cost mutual funds.

While there are good arguments onboth sides, I prefer currency unhedgedfunds, at least in the current environment.The huge budget and trade deficitswe as a country have been experiencingwill catch up with us, so it is worthwhileto have some protection against a fallingUS dollar. As always, invest throughindex funds, exchange-traded funds, or

Chandan Sengupta, author of The Only

Proven Road to Investment Success (John

Wiley; 2001) and Financial Modeling Using

Excel and VBA (John Wiley; 2004), currently

teaches finance at the Fordham University

Graduate School of Business and consults with individuals

on financial planning and investment management. He welcomes

questions or comments at chandansen@aol.com.