A key investment lessonfrom the past 2 years isthat if your stock portfoliois not internationallydiversified, you shouldseriously consider putting some of it inforeign stock funds. Despite this initiative,international diversification posesmany challenges, and if you are not careful,you may end up hurting rather thanhelping your portfolio's performance.
Let us start by looking at a few numbers.The 2005 and 2006 (through November2006) returns on the VanguardTotal (US) Stock Market Index fundwere about 6% and 14%, respectively.The returns on the Vanguard Total InternationalStock Index fund for thesame periods were 16% and 29%, andthe returns for the Vanguard EmergingMarket Stock Index fund were 24%and 33%. Clearly, for the past 2 years,if your portfolio was internationallydiversified, it would have performedmuch better. But you cannot make investmentdecisions based on 2 years ofresults, because most of the time chasingrecent winners only leads to regrets.
Why Diversify Internationally?
So the two questions you should askright away are: Why have the internationalmarkets been doing better, and isthis performance likely to continue?
The answer to the first question isthat a great deal of this growth has todo with the weakening of the dollarand the strong performance of theemerging market stocks. If you investin stocks of a foreign country and thedollar weakens 10% relative to thecurrency of that country, then thatinvestment will gain 10% more in dollarsthan in its local currency.
Unfortunately, with no resolve inWashington to rein in our huge budgetand trade deficits or reduce our consumptionof imported oil, it is almostcertain that the dollar will continue todeteriorate over the years, albeit withups and downs. International diversificationshould continue to pay in thefuture as long as you have at least a 5-year investment horizon.
The economies of developing countrieslike India and China are growingat rates of 8% or more per year,whereas those of the developed countries,including the United States, arelikely to grow at rates of 3% to 4%per year, if that much. Ultimately, thegrowth of an economy gets reflected inits stock market.
How to Diversify
International diversification is morecomplicated than investing in USstocks because you have a large numberof countries and stocks to choosefrom, and you do not have any understandingof the economies and marketsof these foreign countries. These impedimentsmake it is easy to fall in thetrap of chasing the recent winners,which is always dangerous.
If you are going to do it on yourown, your best bet is to stick to theVanguard Total International StockIndex fund or something similar. This isnot an ideal solution, and holding sucha fund of funds will incur some unnecessarytax costs if you hold it in a taxableaccount. Nonetheless, trying to doanything more sophisticated on yourown, without spending a lot of time onresearch, can be counterproductive.
You may choose to seek professionalhelp because a knowledgeable professionalshould be able to do muchbetter than holding the above type ofall-in-one funds. But, choose carefullybecause most professionals do notunderstand international markets thatwell and may also steer you toward thesame countries and funds that havedone well in recent years.
Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001) and Financial Modeling UsingExcel and VBA (Wiley; 2004), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consults with individualson financial planning and investment management. He welcomesquestions or comments at firstname.lastname@example.org.