How Much Foreign Exposure Do You Need?

If you're wondering how much of your stock portfolio you should invest overseas, you're not alone. It's become a fiercely debated question among financial planners and others in recent years. For a long while, though, the consensus answer for the right international allocation stood at about 20%.

The reason this consensus endured stemmed from the idea that it's inherently more risky to venture abroad than to stay stateside. It's true that emerging markets can still fluctuate dramatically. And less-stable political environments and different accounting standards may make international investing a bit trickier, despite improvements on both fronts over the past decade. However, the evidence suggests that investing overseas doesn't necessarily require you to take on more risk. Over the past five years, for instance, the typical foreign large-growth and large-value mutual fund wasn't any more volatile than its domestic counterpart.

These days, many folks argue globalization has weakened the case for international investing. Traditionally, foreign stocks have been touted for their diversification benefits. Historically, they've zigged when the U.S. has zagged. But now that economies are more interconnected than ever, we should expect stock markets around the world will move increasingly in step with one another. (If you don't believe us, recall the U.S. market's swoon earlier this year when China's stock market fell 10% in a single day.) Even if that's the case, though, different currencies and interest rates across countries make it likely that U.S. and foreign stocks will still perform differently at times. That's certainly been the case in this decade. While the typical U.S. large-blend fund returned 11% over the past five years, for instance, the average foreign large-blend fund is up 17%.

In the end, the real debate isn't over whether you should have international exposure but rather how much and what kind. If the old consensus isn't a reliable guide, what is? Below, we'll look at some considerations worth keeping in mind and discuss what you should think about if you decide to increase your international exposure.

Should Your Portfolio Look Like the Global Market?
Some investors heavily weight U.S. stocks out of the mistaken perception that U.S. stocks are less risky, patriotism, or perhaps familiarity (you'll know more about Wal-Mart (NYSE: - ) than you will an Indian or Chinese retailer, for example). But despite its economic might, the U.S. only accounts for approximately 45% of the world's total stock market value. So, if you've got 80% of your stock holdings invested domestically, you're making an enormous bet in favor of the U.S. market.

Finance or economics textbooks might suggest eliminating that bet entirely. But doing so wouldn't be as simple as sounds. Even an all-U.S. stock portfolio would give you considerable exposure to foreign markets. As Slate's Daniel Gross recently noted, the average company in the S&P 500 earned 40% of its revenues overseas in 2006. The opposite is true, too. Drug firms such as GlaxoSmithKline (NYSE: - ) and Novartis (NYSE: - ) may be based in Europe, but they make most of their money in the U.S. Adding to the muck is the fact that many domestic-equity mutual fund managers have been increasing their foreign stakes lately, which means you might have more international exposure than you thought. U.S.-focused Fidelity Magellan (NASDAQ: - ), for example, has more than 20% of its portfolio invested overseas.

Moreover, it makes sense to preserve some bias in favor of the U.S. Here's the theory why: The reason you invest is so that you can spend money in the future. Partly, you'll be buying what economists call "nontradable goods"--goods and services that must be produced locally. One example is restaurant service, which you'd be hard-pressed to import. Emphasizing U.S. stocks is one way to guard against future price fluctuations in nontradable goods, because their future prices will mostly reflect local conditions. When the price of nontradable goods rises, presumably the firms offering them will become more profitable and have higher share prices as a result, benefiting the investor with the U.S. bias. It's worth noting, however, that this rationale has waned considerably over the past couple of decades. Increasingly, the U.S. has found new ways to take advantage of more-efficiently produced goods and services abroad. Think about the last time you called a customer-support hotline. You'll often talk to someone in India, but 20 years ago, few would have thought you could locate customer-support operations outside the U.S.

So, if simply mirroring the globe's market-cap allocation isn't the right strategy, what's the right international-stock allocation? No one allocation is applicable to every investor, but clearly it lies somewhere in between today's conventional 20% weighting and the 55% stake you'd have if you wanted to mirror the world stock market. Ibbotson Associates, a Morningstar-owned company that specializes partly in asset-allocation issues, suggests investors keep a third of their stock holdings overseas. That's a useful starting point, as are some of the target-retirement funds out there. These offerings are designed by fund companies as one-stop investment solutions and often reflect a considerable amount of research into what's the ideal international allocation. While some firms, such as T. Rowe Price and Fidelity, opt with the traditional 20% to 25% foreign weighting, others are more adventurous. Putnam and AllianceBernstein have more than 33% of their stock holdings in foreign stocks. In the end, though, there may be no right answer, as my colleague Gregg Wolper argues.

How Should You Increase Your Foreign Exposure?
If you think your portfolio needs more of an international flavor, you should first start by seeing how much foreign exposure you already have. Premium Members who have entered their portfolios on Morningstar.com can click the X-Ray tab within Portfolio Manager to find out. You'll be able to see how much of your total portfolio is invested overseas, broken down by world region. Free users may obtain a similar view by using the Instant X-Ray tool.

Should you want to boost your foreign stake, keep some things in mind. For one, you want to build your international portfolio using the same principles as you'd construct your domestic holdings, putting steadier large-cap holdings at the core with niche offerings at the periphery (for more on selecting a core holding, click here). Similarly, you want to keep an eye on expenses and manager tenure, just as you would if you were buying a domestic holding. One good source of good core holdings is our foreign large-blend category. Premium Members can find a list of our favorite funds in the category here.

If you've already got a core foreign holding, consider branching out into foreign funds that focus on mid-caps and small caps. These stocks have the advantage of being less tied to the global economy, making them better portfolio diversifiers. Premium Members will find our favorite foreign mid- and small-value funds here, while our favorite foreign mid- and small-growth funds are here. You might also consider juicing your foreign portfolio with a dose of emerging markets. You may not need a dedicated emerging-markets fund--your other funds may already give you plenty of exposure. Our favorites in this group are here.

If you're reducing your domestic holdings to make room for more foreign fare, don't forget the tax consequences of your actions. It might make more sense to cut back first in nontaxable accounts such as your 401(k) or IRA first so you don't end up triggering taxable gains. Another alternative is to stop adding to your domestic holdings and use the proceeds to fund your additional international investments.

Finally, keep in mind that international stocks--especially emerging markets--have enjoyed quite a run in recent years. You shouldn't invest expecting the recent past will repeat itself. Instead, focus on creating a sound, long-term plan and stick with it.

Christopher Davis does not own shares in any of the securities mentioned above.