Safeguard your portfolio with international stocks

Despite lackluster returns, you’ll be glad to own them

Published: February 19, 2015 05:30 PM

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Since the Great Recession, U.S. stocks have been the envy of the world. Although the recovery has been tepid at times, the slow, steady upward trajectory of the U.S. economy and the stock market has been preferable to the turbulence in international economies and markets.

So why is it that financial advisers and the financial media persistently encourage U.S. investors to diversify their equity holdings into international markets? (We include ourselves as part of Team Encouragement.) The reason: Over the long run, history shows that investing both here and abroad offers greater returns than sticking with a domestic-only portfolio. And diversifying across asset classes, despite the greater risks of international stocks, will serve to smooth your returns.

Investing in foreign stocks, though, can be a tough sell. Investors tend to stick a little too close to home when creating a portfolio. Even though non-U.S. stocks account for half of the world’s market capitalization, only about a quarter of a typical American investor’s stock portfolio is devoted to them, according to International Monetary Fund data.

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The reason: that universal trait known as home bias. We tend to prefer to invest in what’s more familiar, even if we know the virtues of international diversification. (If it’s any comfort, this isn’t a case of American exceptionalism: British investors own a preponderance of U.K. stocks, Australian investors own mostly Australian stocks, and so the trend goes.)

Then there’s the recent performance of foreign equities, which have ranged from mediocre, in the case of many developed nations, to borderline abysmal, in the case of the “BRIC” emerging-market economies (Brazil, Russia, India, and China). But over the past five years, U.S. equities have outpaced those of any other region, returning 15.6 percent annually since September 2009. That’s more than twice the return of the stocks of Europe, Japan, and emerging markets.

Foreign equities are also more expensive to invest in than domestic stocks. The average expense ratio of an emerging-market mutual fund is 1.08 percent annually, costing more than twice that of the average domestic fund, according to the Investment Company Institute, the trade group representing the mutual-fund industry.

Even so, we still think there’s an essential role for international stocks in almost any portfolio. In fact, the past few years have made international stocks even more compelling, despite their on-­the-­surface disadvantages. Even for the risk-averse investor, there is, paradoxically, a role for riskier international stock mutual funds or exchange-traded funds.

The four engines

Nouriel Roubini, an economist even more pessimistic than most, recently likened the world economy to a jetliner, one that needs all four of its engines operational. Though we disagree with his conclusion—he suspects the world economy, with three of its engines sputtering, will soon be making an emergency landing—we quite like his metaphor. So here’s a brief recap of the four world economic engines, how their economies have been reflected by stock prices, and which are more or less expensive.

U.S.—the leader

Defying almost every adversity, U.S. stocks have, as a whole, provided Buffett-like returns to even average investors. The Standard & Poor’s 500 Index, since September 2009, has gained 15.6 percent annually. Even more remarkable, it has done so with little volatility: Its last hiccup (or, as Wall Street calls it, correction) was in 2011. Usually you can count on those at least once per year. And corporate earnings, so far, have mostly kept up with prices, so the valuations are more or less justified. But they are slowly increasing. The price-to-earnings ratio of U.S. stocks is 18.6—not as high as, say, the bubble levels of 2000, but certainly higher than the long-term price-­to-­earnings ratio average of 16.

Europe—the sickly ones

Then there’s Europe—the constellation of developed economies cursed with a common currency. Meant to unify the continent, the 14-year-old Euro has at times had the opposite effect, with weaker European nations such as Spain and Italy at odds with Germany over monetary policies. As a consequence, many European nations, including Germany, have endured double-­dip recessions, and as a result, European stocks have languished.

Japan—aggressively printing new money

Japan, the world’s third-largest economy behind China and the U.S., has been having economic problems, too. Its economy shrank almost 2 percent last summer, and deflation—an economic demon that Japan has been fighting for almost a quarter-century—was threatening to further cripple the economy.

But last October, the Bank of Japan decided on a new quantitative easing policy, one even more radical than the Federal Reserve’s in recent years. It’s too early to tell whether those policies will work, but at least in the short term, Japan’s languishing stocks were cheered—the Nikkei 225 index (Japan’s equivalent of the Dow Jones industrial average) rose to levels not seen since 2007.

Emerging markets—the bargain

Emerging markets, at least as represented by “BRIC” nations, have been a disappointing investment. The best thing you can say about them is that they haven’t lost investors much money since the recession of 2009.

The problems of those and other emerging-­market economies are varied. For producers such as China, it comes down to the economic slowdown. Even though it still grows its economy at a 7 percent annual rate—a level that would be considered overheated anywhere else—the slowdown resulted in a reassessment of the valuation of Chinese equities.

For commodity producers such as Brazil, China’s slowdown means less demand for raw materials, thus affecting its economy. Russia faces political uncertainties on top of collapsing prices for oil, the commodity that much of its economy is based on. The only bright spot among the larger emerging markets is India, whose stocks reached all-time highs in 2014.

So four economies, each with its own predicament. The U.S. market appears the safest but also the most expensive. Emerging-market economies are relatively cheap at eight times earnings but come packaged with the most uncertainty. Japan and Europe have their own challenges centering on their respective currencies.

A prudent move

What’s your best option? There is no clear answer. What we do know is that spreading your investments across some or all of those economies is more prudent than investing exclusively in one—even if that one is the U.S. Just because the U.S. has outperformed the rest of the world since 2009 doesn’t mean that will persist for the next five years. It’s always possible that U.S. stocks could spend a prolonged period in the wilderness, the way Japanese stocks have since 1990. By owning both U.S. and foreign stocks, you’re not assuming more risk but insuring yourself against a domestic stock-­market fall.

If you don’t believe us, you might believe the companies that manage your 401(k). Look at the target-date funds they offer. Those one-stop-shop investments in turn own funds—and the three largest target-date fund families allocate significant percentages of their stock holdings internationally. Vanguard, for example, allocates 29 percent to international stocks; Fidelity, 32 percent; and T. Rowe Price, 33 percent. 

Editor's Note:

This article also appeared in the January 2015 issue of Consumer Reports Money Adviser

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