Pays to Look Over There

In the wake of Tuesday's whatever that was, I had some comments come in on my blog noting that foreign investing did not offer any zig to the U.S.' zag.

This is worth dissecting so that do-it-yourself investors have the correct expectations about what foreign issues can and cannot do for them.

You have probably read the virtues of foreign investing:

• It reduces volatility.
• It improves returns.
• It offers diversification.

While these statements are usually true, they do not necessarily apply to one-off events, panics or crises.

Foreign Investing Potential

The first chart below captures what foreign diversification can potentially do for you.

On first glance, you will see that if you had owned Australia, it would have helped weather the U.S. bear market by a noticeable amount, but it was not a cure-all.

In a very short-term move during which most markets have a heavy decline, it is unlikely that a specific market will somehow be immune. And as you can see, Australia clearly felt the Sept. 11, 2001, attacks at almost the same magnitude as the U.S.

History shows that we don't need to be very concerned with spikes down.

Look at the bear market that occurred in the U.S. at the beginning of this decade.

It is clear that over a fairly lengthy period, Australia did offer some protection (declining about half of what the U.S. market did in the time charted) and less volatility.

This is the type of value potentially offered by foreign markets.

Click here for larger image.

The Single-Country Answer

Notice that during the same time period, owning iShares MSCI EAFE Fund (EFA Quote) offered no real diversification -- in other words, protection.

Click here for larger image.

Too many investors -- pros and individuals alike -- give EFA too much credit for being the best tool for foreign investing when looked at over a multiyear stress test (which is far more important than a bad week). I believe this is incorrect.

My reasoning for this is simply that the broader you go, the less zigzag effect you can possibly capture.

If this is true, and I believe that it is, then you will need to drill down to a country level. This is potentially more work than some folks will want to do, but without the effort, your portfolio will not capture the full benefit.

There are plenty of great stocks to own from Europe, but most of the continent will correlate closely to the U.S. and, as a result, won't offer the best possible diversification.

For my money, if I could only have one other developed country, it would be Australia, because its economy is more commodity-based and its stock market has proven over time to offer diversification when it is most needed.

This next chart captures the four largest countries by their corresponding ETFs: iShares MSCI United Kingdom (EWU Quote), iShares MSCI France (EWQ Quote), iShares MSCI Germany (EWG Quote) and iShares MSCI Japan (EWJ Quote), along with the S&P 500. The S&P 500 turned out to be the best of the bunch (by a very slight margin). Well, hooray for the U.S.A., I suppose, but this helps to explain why EFA did nothing to buffer losses.

Click here for larger image.