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Too Much of a Good Thing by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research July 25, 2008 Reprinted from the July 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. We've long preached the benefits of making international stocks part of your long-term asset allocation plan. Our recommended target: 25% of your total equity exposure. So, if your overall equity target is 60%, we'd say to put 15% (0.60 x 0.25) in foreign stocks. In the late 1990s when international markets lagged domestic, clients frequently asked, "Why so much in international?" Now, after five years of stark outperformance by international equities—which make up 58% of the world equity market and 73% of global GDP1—the common refrain is, "Why not more in international?" There are strong reasons for being cautious on international equities in the short term, particularly if the dollar were to strengthen (see "Global Inflection Point?"). But regardless of the direction of the dollar (which is very tough to forecast accurately), we think increasing your international equity allocation to the current market weight of 58%—or even 50%—just introduces too much risk into a portfolio, especially for retirees living off their investments. Here's why.  Rising dollar risk For dollar investors, a huge part of the returns on international equities can depend on currency moves. Consider the "U.S. Dollar Index Versus Six Major Currencies" chart above, which illustrates the dollar's relative performance over the last 40 years. The two arrows indicate periods (1980–1985 and 1995–2002) when the dollar strengthened substantially. Now look at the "Returns During Strong-Dollar Periods" graph below, comparing the performance of the S&P 500® during those periods with the MSCI EAFE® Index of international stocks, denominated in dollars and local currencies.  The 1980–1985 period was an exceptional period for international stocks. In local currencies, the EAFE returned a cumulative 126%—well in excess of the not-too-shabby 85% for the S&P 500. However, most international equity funds don't hedge their currency exposure, and when returns are converted back into dollars, the EAFE return was cut to 43%. In other words, even though foreign markets did well, U.S. investors would have enjoyed only about one-third of that performance, due to the strengthening dollar. The results were even more dramatic from 1995 to 2002. The rising dollar practically wiped out all of the 60% gain that the countries in the EAFE Index generated in local currencies! Currency mismatch risk Taking on some currency exposure is OK because it helps to diversify, but too much is a risk. Remember, you're likely doing most of your consuming in U.S. dollars. If you're planning on funding your retirement with your portfolio and it's heavily denominated in foreign currencies, then that currency mismatch creates an extra risk if the dollar strengthens. That's because when you convert your international holdings into dollars, those investments wouldn't buy as many dollars—so you would have less to spend. Small-cap and emerging markets risk Much of the international economic and stock market growth has been concentrated in smaller companies and emerging markets. Not surprisingly, these are the riskier environs of non-U.S. markets: Past data suggests that if an increase in the non-U.S. allocation is warranted, it should be in those areas. It certainly makes sense to spread your international equity exposure across not only stocks in big, developed countries, but in smaller firms and emerging markets, as well. But if you allocated 58% of your equity portfolio to international, that would imply 10% in small-caps and 10% in emerging markets. Given their historic volatility, we think that's just too risky. Within our 25% international equity allocation, we'd put 5% in small-caps and 5% in emerging markets. The bottom line: We're big believers in international investing, but we also believe that a good thing can be taken too far. Important Disclosures 1. Market capitalization data is from Thomson ONE as of December 31, 2007. The capitalizations are float-adjusted and include a minimum liquidity requirement. 2007 GDP data for 48 countries is from the International Monetary Fund as of April 2008. 2. The six currencies and their respective weights: euro, 57.6%; Japanese yen, 13.6%; British pound, 11.9%; Canadian dollar, 9.1%; Swedish krona, 4.2%; Swiss franc, 3.6%. International investments are subject to additional risks, such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. Small-cap stocks have historically been more volatile than the stocks of larger, more established companies. The S&P 500 Index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. Diversification and asset allocation strategies do not assure a profit and do not protect against losses in declining markets. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Examples provided are for illustrative purposes only and are not intended to imply future results. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0708-4221) Return to Top |
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