Ignore Foreign Markets at Your Peril

It may no longer be popular, but there's still a strong case to be made for foreign diversification.
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While the U.S. economic boom and the bull market it's created show no signs of abating, big economies around the world are less impressive. And it's little surprise that Americans have been reluctant to invest their money abroad.

Last week, Japan disappointingly slipped back into recession and the country's key stock index languishes at half the all-time high it hit more than a decade ago. The

European Central Bank

raised rates just as Germany -- a third of the region's economy -- is struggling to get on its feet. Even though some of the world's stock markets are doing well by either absolute or relative measures, they rarely stir the imagination the way visions of

Nasdaq

5000 can.

And given that many big U.S. blue-chips, like

Coca-Cola

(KO) - Get Report

and

Colgate Palmolive

(CL) - Get Report

, now derive significant revenue streams from overseas markets, some observers suggest you can keep all your money at home and still have exposure to foreign markets. No less an investing luminary than

John Bogle

, founder of the

Vanguard Group

, has argued that placing money abroad is no longer necessary for ensuring a well-diversified portfolio. U.S. equities, which constitute about half of the world's market capitalization, seem indomitable. The benefits of investing abroad appear outweighed by the risks of missing the party at home.

And yet, that perception is wrong.

Over the last year, the

Morgan Stanley Capital International's Europe, Australasia and Far East

index, or EAFE, the mostly widely-recognized benchmark for international equities, is up 19%, while the

S&P 500

, the comparable American measure, has risen only 8%. And that divergence creates potent benefits for investors willing to move money overseas for the long term, even if it means missing a little of the big rally at home, say independent financial planners. The message: Ignore overseas markets at the peril of your portfolio.

"For a long period over the last couple of years, this hasn't been a popular stance," concedes Tim Kochis, president of

Kochis Fitz

, a financial planning firm in San Francisco. Nonetheless, he recommends that investors consider putting at least 20% of their portfolio in international assets because of the combination of risk reduction gained by spreading money over more investments and the potential for growth abroad.

Diversifying overseas works because even though big global markets may often move in the same direction, they rarely move with the same magnitude. Sure, when the

S&P 500

is up, Japan's

Nikkei

and Germany's

Dax

are probably going to rise -- but not by the same degree. Baltimore-based mutual fund company

T. Rowe Price

says that over the last 10 years, market movements have been correlated roughly half the time. The rest of the time gives one part of a portfolio -- the domestic or the foreign -- an opportunity to outperform the other.

To illustrate the value of international investing, T. Rowe Price created a blended portfolio of 70%

Wilshire 5000

index -- coincidentally the benchmark

Fed

Chairman

Alan Greenspan

follows most closely -- and 30% EAFE to illustrate the return benefits of diversification. Price's numbers wizards rebalanced the portfolio at the end of each year to ensure the next year started with the same 70%-30% split. The study covered the period between 1971 and 1999.

The results, while not dramatic, offer a convincing argument for placing money overseas. The blended portfolio handed back an annualized return of 14.35%, while the EAFE index returned 14.13%. The Wilshire portfolio, even though it included the roaring '90s, was the worst performer with a return of 14%.

Of course, replicating these indices isn't easy for the individual investor. So we asked Stephen Murphy of the statistics team at fund tracker

Morningstar

to assemble a mutual fund portfolio that would mimic a Wilshire/EAFE portfolio. He chose the

(VTSMX) - Get Report

Vanguard Total Stock Market Index, which tracks the Wilshire and holds blue-chips like

Microsoft

(MSFT) - Get Report

,

General Electric

(GE) - Get Report

and

Cisco Systems

(CSCO) - Get Report

, to represent the domestic portion of the portfolio. He picked the

(NIEAX) - Get Report

MainStay EAFE Index, which benchmarks EAFE and owns big companies like

BP Amoco

(BPA)

,

Nippon Telegraph and Telephone

(NTT)

and

Nokia

(NOK) - Get Report

, to embody the overseas portion.

A quick look at the numbers suggests mixed results. Over the one-year period, the blended portfolio turned in a 22.43% return, while the domestic-only handed back 21.92% and the foreign-only 23.32%. But over the five-year period, the domestic fund had the better 24.86% return to the blend's 20.93% and foreign's 11.75%.

That may convince some that diversification works in the textbook, but not in practice. Maybe, but consider this: Five years is a short period of time, and one that has seen overseas markets, even big developed economies, slog while the U.S. served as the engine of global growth. The Asia crisis raged, Russia's economy collapsed, Japan struggled out of its worst postwar recession only to fall into a new one and Germany stagnated. Having international exposure trimmed the overall portfolio's gains, but didn't snuff them out. What will performance be when the rest of the world finally starts leading rather than following the U.S.? What will performance be if -- and this is a big "if" -- the U.S. bull is finally corralled?

"The catch is that you don't always have all your money in the right thing," says Harold Evensky, a financial planner at

Evensky Brown & Katz

in Coral Gables, Fla., who recommends investors consider putting about one-third of the equity portion of their portfolios in international stocks.

"But you don't have all your money in the wrong thing either," he adds.

If you're in it for the long run, it's probably better to be hedged.

Andrew Morse aims to provide general investing information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.