Why Invest Internationally?

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Why Invest Internationally?
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
May 23, 2006

Many investors think diversifying their equity portfolio means buying large- and small-cap stocks. If you fall into that camp, you might want to broaden your investing outlook, by looking over the horizon and investing internationally.

Remember that markets, even those in the United States, are cyclical. Since timing those cycles perfectly is impossible, it's important to diversify. A portfolio properly diversified across and within asset classes is better equipped to ride out these cycles, as one asset class may be rising as another is falling. Adding international equities to your portfolio gives you another type of diversification—geographic.

If you're a "Buy American" investor, put your patriotic emotions aside for a minute and consider that from 1970 to 2005—the U.S. market (as represented by the S&P 500® index) never ranked as the top performing developed market for any one year. Remember just 100 years ago, the United States was considered an emerging market!

Nonetheless, many investors shy away from international investments and display what's commonly called a "home-country bias." This may be due to geopolitical turmoil, or the fact that less information is immediately available—so people are simply less familiar with international investing. Also, in the mid- to late-1990s, many new investors entered the markets while the United States was experiencing a period of outperforming broad international indexes. That trend, however, has reversed in recent years, as Figure 1 shows. (Note the cyclical pattern in market performance.) Also, the performance difference is significant during each cycle. Therefore, your portfolio should have a broad exposure that includes international, since you cannot perfectly time the market.

Regional returns are cyclical: U.S. vs. international stock performance (Figure 1)

Source: Schwab Center for Investment Research with data provided by Ibbotson Associates.
Note: Wilshire 5000 Index is the proxy for U.S. stocks. MSCI EAFE Index is the proxy for international stocks.

The two primary reasons why you should include international investments are the potential to enhance returns through a larger universe and to reduce risk by including an asset class that may respond differently to various market cycles and events. Let's take a look at each:

The larger universe
Any way you look at it, if you close the investing borders of your portfolio, you're missing out on a lot of potential opportunity outside the United States.

About half of the world's market capitalization is outside the United States. (The total market capitalization of U.S. stocks was $11.8 trillion as of Feb. 14, compared to the total world investable market cap of $25 trillion.¹)
Outside the United States, there are 49 countries with publicly traded investable securities in which to find investing opportunities.¹ More than 37,000 companies are listed globally, compared to about 5,000 companies listed on U.S. exchanges.²
According to the U.S. Census Bureau, approximately 95% of the world population lives outside of the United States. Also, about 71% of world gross domestic product is generated outside the United States.³
Many top companies are found outside our borders: In the communication sector, the largest company (by net sales in U.S. dollars) is Nippon T&T from Japan. In the financials sector, German insurance company Allianz takes the lead; and in the utilities sector the top seven companies all reside outside of the United States.⁴ Other well-known international companies include Sony, Volkswagen, Nokia, Toyota and Nestle.
Looking at international trade, the value of foreign goods and services sold to the United States alone reached $2.0 trillion in 2005, according to Moody's. Look to these companies, many whose products you may use, for investment opportunities.

Greater diversification
Building portfolios with the least amount of risk for a given level of return is the foundation of modern portfolio theory. Including international equities in your portfolio helps reduce risk by adding diversification. Professionally managed endowments and pension funds have long recognized the diversification benefits of an international allocation. According to Pension & Investments, the average allocation to international equity for the top 200 U.S.-based pension funds is about 18% of total fund or 25% of total equity holdings.

We confirmed that portfolios with some exposure to international equities had lower risk (as measured by standard deviation) than an all-domestic portfolio for approximately the same level of return. The Schwab Center for Investment Research® compared a portfolio invested exclusively in domestic equities (using the Wilshire 5000 index as a proxy) and another portfolio with 75% allocated to domestic equities and 25% to international equities (using MSCI Europe, Australia and Far East Index) for the period 1971 through 2005. The 25% allocation to international represents the approximate recommended proportion within total equity across the Schwab model portfolios. The table below summarizes the results:

	Annualized return	Risk
International index	11.2%	18.7%
Domestic index	11.4%	17.6%
75-25 portfolio	11.6%	16.3%

Source: Schwab Center for Investment Research, with data provided by Ibbotson Associates. Time period is January 1971 through December 2005. Wilshire 5000 TR index represents domestic, MSCI EAFE net of taxes is the proxy for international. The 75-25 portfolio is rebalanced monthly. Risk is measured by the annualized standard deviation of monthly returns.

Another potential benefit to investing internationally is the added diversification layer of currency. You not only get exposure to a company operating in another country—with potentially unique products and customer sets—but also to the other currencies. For example, a declining dollar will boost your international investments' performance in U.S. dollars, since your investments are held in foreign currencies. The reverse would be true as well in a strong dollar environment.

During the late '90s there was a lot of talk about the increasing correlation between domestic markets and international markets and the lower benefit gained by investing internationally. This isn't surprising given the volatile nature of the market during that period and the fact that correlations do increase during volatile periods, such as the recent past global tech and telecom bubble and subsequent downturn. Note that the correlations have come back down recently, as shown in Figure 2. However, even with increased correlations, there are still benefits to adding international investments. International and U.S. stocks often do not move in tandem. As Figure 3 shows, 40% of the months that the broad U.S. stock market is down, international stocks are up, compared to 13% of the months for small-cap stocks when compared to large-cap.

It makes sense for most investors to consider adding international investments to their portfolio as part of a disciplined investment process. The increased opportunities and ability to reduce risk are the reasons why you should think about expanding the borders of your portfolio.

Three-year rolling correlation of monthly returns: U.S. and international stocks (Figure 2)

Source: Schwab Center for Investment Research with data provided by Ibbotson Associates.

Better diversification for U.S. stocks: International versus small cap (Figure 3)

Source: Schwab Center for Investment Research with data provided by Ibbotson Associates. January 1971 to December 2005 returns. Wilshire 5000 Index is the proxy for U.S. stocks; MSCI EAFE Index is the proxy for international stocks. Russell 2000 represents domestic small-cap; S&P 500 represents domestic large-cap.

1. Based on the Morgan Stanley Capital International (MSCI) country index statistics.

2. According to the World Federation of Exchanges, an international organization formed in 1961 to promote co-operation among the world exchanges. Today membership encompasses 57 exchanges from all over the world. Members together account for over 97 % of world stock market capitalization.

3. International Monetary Fund, World Economic Outlook Database, September 2005. GDP is based on current prices converted to U.S. dollars.

4. FactSet Research System.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed. The historical performance measurements used are not intended to represent or imply any future results.

International investments are subject to additional risks such as currency fluctuation, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks. Diversification strategies do not assure a profit and do not protect against losses in declining markets.

The S&P 500® Index is an index of widely traded stocks.

The MSCI EAFE® Index (Europe, Australasia, Far East)is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 2005, theMSCI EAFE Indexconsisted of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

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