Diversification, one of the bedrock principles of investing, didn't work in 2008. There was simply no place to hide in the global slowdown, and international stocks struggled more than U.S. shares: The S&P 500 fell 38.5% last year, and benchmark international indices did even worse. The MSCI EAFE (Morgan Stanley Capital International/Barra Europe, Australasia and Far East Index), a basket of large-company shares in developed markets outside the U.S. and Canada, dropped 45.1%. The MSCI Emerging Markets Index, meanwhile, slid 54.5%. Still, it's wise to include a broad mix of stocks in your portfolio: growth and value, large-cap and small-cap, a variety of sectors and, yes, international shares. Diversification provides the best opportunity for long-term growth, while minimizing risk. And many advisers believe investing internationally can maximize those benefits. Historically, that's been the case. Consider these numbers through the end of 2007. Foreign stocks, and those in emerging markets, offered the best long-term returns.
Why invest internationally? Since more than half the world's stocks are outside the U.S., spreading your money can reduce risk and allow you to invest in global growth. It can also protect your portfolio when the dollar weakens. Diversification usually works because foreign markets tend to move differently than ours, and may offer gains when U.S. stocks retreat. While foreign markets can add risk, they also offer greater potential. In late 2008, T. Rowe Price ( TROW) portfolio manager Ray Mills pointed out that European and emerging-market stocks were trading at 9.2 and 8.7 times earnings, compared with 12.5 for Japan and 11.6 for the U.S. "Valuations are exceptionally cheap, with many companies selling for less than book value or at extremely low historical P/E ratios," Mills said in a press briefing. "Emerging markets are on sale."
Finally, many of the world's best companies are based overseas. Without international stocks, your portfolio could lack such stalwarts as GlaxoSmithKline ( GSK), Royal Dutch Petroleum ( RD) and Nestle ( NSRGY). Likewise, you could miss out on smaller names, such as those that boosted the BRIC countries -- Brazil, Russia, India and China -- in recent years. How to do it? While it's possible to invest in individual international stocks on American or foreign stock exchanges, for most investors, mutual funds or exchange-traded funds are the best way to invest internationally. (Unlike mutual funds, ETFs trade all day long on a stock exchange, typically with lower expenses.) The prime reason? Funds' diversification can cut risk, and allow you to rely on indices or experts to pick stocks in unfamiliar markets. Since the number of funds has skyrocketed in recent years, investors can now target virtually any slice of the market. Global funds typically include North American stocks as well as foreign issues, while international funds avoid U.S. names. Regional and country funds focus on stocks from a geographic area or nation. Each category offers funds with any variety of focus: small-cap or large, value or growth, tech or industrials -- the list goes on and on. Choosing investments: There's no magic formula for choosing foreign funds. The right foreign funds for you depend on the construction of your portfolio, along with your risk tolerance and time horizon. Still, you can rely on a few rules of thumb.
- Consider how much international exposure you want. Many advisers recommend a foreign allocation of 10% to 20%, while others advocate as much as 40%.
- Be aware of how much international exposure you already have. Domestic funds may include foreign stocks.
- Consider exposure to both developed regions and emerging markets.
- Think about limiting exposure to multinationals and large-company world funds, which may correlate strongly with domestic markets.