With foreign markets sizzling in recent years, investors poured into international mutual funds. Now that markets appear shaky in countries like China and Italy, some shareholders are dumping their funds -- but they might be wise to reconsider.

A growing group of investment analysts argues that typical investors should keep at least 50% of their equity assets in foreign stocks. The analysts note that about 25% of all equity fund assets are in international funds.

"Very few individuals or institutions hold enough foreign stocks," says Burton Malkiel, a Princeton economist and author of the classic

A Random Walk Down Wall Street


Only a minority of experts advocate putting most assets abroad. But in recent years, plenty of investment pros have been raising their recommended foreign allocations. Financial advisers who once invested 10% of portfolios overseas are now raising the allocation to 20% or 30%.

The increased emphasis on foreign stocks can be traced partly to the growth of markets abroad. During the late 1990s, foreign shares accounted for about 30% of total world stock market value. Since then, the foreign total has climbed to about 56%, as markets such as India and Brazil have soared while Wall Street lagged.

Some advisers say that investors should steadily raise their foreign allocation as overseas markets grow.

"It is hard to predict whether the U.S. is going to outperform other equity markets going forward," says Stephen Evanson, a financial adviser in Carmel, Calif. "It's best to hedge your bets and make sure that your portfolio matches the weightings of global markets."

Evanson argues that foreign stocks can provide diversification for U.S. investors. A globally diversified portfolio can deliver relatively steady results, because sometimes stocks in one region may be racing while other markets trail.

This has been amply demonstrated recently. During the five years ending in April, foreign large-blend funds returned 19.25% annually, while comparable U.S. funds returned 10.52%. During the five years through December 2000, U.S. large-blend led, returning 16.19%, compared with 9.19% for foreign peers.

While it pays to have a solid foreign allocation, investors should be wary of holding much more than 40% or 50% of assets abroad, says Fran Kinniry, a principal with Vanguard Group.

Kinniry says that when an investor moves from having no foreign holdings to keeping 20% of assets abroad, there is a substantial diversification benefit that economists sometimes call the "free lunch." As diversification increases, the odds of suffering a bad loss fall. In other words: Investors can enjoy greater expected returns without taking on more risk.

As the foreign holdings surpass 40%, the diversification benefit begins waning, and disappears entirely by the time that the foreign allocation hits 100%.

"When you start moving past 50% in foreign stocks, then you may not be doing much to lower risks," says Kinniry. Still, there could be special circumstances when some investors should keep more than half of their assets abroad, says Michele Gambera, chief economist of Ibbotson Associates.

Gambera cites the example of a car salesman who works for commissions. If the U.S. economy slows, the salesman's income could fall. At the same time, the

S&P 500

is likely to drop.

"If you think that your paychecks will be correlated to the U.S. stock market, then you should consider putting most of your investments abroad," says Gambera.

Besides urging investors to buy more foreign stocks, some analysts have been advocating an increasingly popular strategy known as global investing. In the traditional approach for holding foreign stocks, an investor might have two funds -- a U.S. domestic specialist and a foreign one. The domestic manager might look for the best U.S. technology companies, while the foreign fund would seek overseas technology champions.

In the new global investing, the manager tries to find the best technology companies without regard to where they are located. A global fund holds a mix of foreign and domestic stocks, and makes no effort to control the overseas allocation.

At a time when more companies are becoming truly global, portfolio managers should have freedom to seek stocks outside national boundaries, says Timothy Noonan, managing director of Russell Investments.

Noonan says the transition to global investing will occur gradually. Russell recently introduced a conservative balanced fund that has 30% of total assets in U.S. stocks, 17% in foreign stocks and 4% in a global fund.

In coming years, the allocation to global funds and foreign stocks may be increased as investors become more comfortable with the new way of viewing markets.

Noonan says that Canadians and Europeans have already adopted global investing. U.S. investors will soon follow.

"Americans have a home-country bias, but that will change as investors recognize that there are many fine stocks overseas," says Noonan.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.