Dr. P.V. Viswanath

pviswanath@pace.edu

Despite Common Wisdom, Trims May Not Be Right
By IAN SALISBURY, Wall Street Journal, July 21, 2007; Page B2

Lifted by a weak dollar and a boom in emerging markets, international stocks have been hot over the past three years, gaining ground much faster than their domestic counterparts.

As a result, foreign holdings have become a bigger part of U.S. investors' portfolios.
FOREIGN AFFAIR

• Background: As international stocks boom, more U.S. investors are being lured.
• Key Warning: If you're thinking of delving into emerging markets, in particular, keep exposure to 10% of your portfolio or less.
• Irony: By investing in classic U.S. companies like GE, investors do get foreign exposure already, and probably will get even more in the future.

Does that mean it's time to trim back? Maybe not.

Wall Street common wisdom holds that when one sector has had a hot streak investors need to "rebalance," selling off some shares so that a single investment doesn't come to dominate their portfolios.

However, the case for international stocks may be an exception. Some evidence suggests many Americans might not be overinvested in foreign companies now for the simple reason that they were underinvested to begin with.

Reasons for investing in foreign stocks include potentially higher returns -- though that certainly isn't guaranteed -- and diversification. At times, foreign markets will move out of sync with U.S. stocks, which can lend overall stability to a portfolio that has a balance of both.

Domesticated Animals

Although there is no hard-and-fast answer for how much money to put abroad, the size of overseas stock markets relative to the U.S. market suggests investors could reasonably stash far more into foreign stocks than anyone believes they do right now.

Foreign stocks constitute more than half the market value of all equities. Based on this distribution, U.S. investors could -- theoretically -- be justified in putting as much as 55% of their stock investments in overseas companies, says Douglas Schindewolf, head of tactical asset allocation at Citi Global Wealth Management.

However, when that Citigroup Inc. unit makes recommendations to its clients and financial advisers, it aims much lower, and suggests putting roughly 30% of stock investments abroad, a level Mr. Schindewolf thinks is more comfortable for investors.

"Most investors have a home-country bias. We have to recognize that in providing advice," he says. "I think it's fair to say that actual investment exposure is below our recommended exposure."

About 13% of Americans currently invest in international stocks and 19% plan to do so over the next five years, according to a recent study by Schroders PLC, a London-based asset management company.

At the same time, about 10% of assets in employee 401(k) plans is in international or emerging-markets investments, up from 4% just three years ago, according to a study of plans sponsored by customers of Hewitt Associates, a human-resources consulting firm. By implication, this figure suggests investors' international exposure in 401(k) plans could be 20% of what they have in stocks.

Similarly, data from the Investment Company Institute, a mutual-fund trade group, indicate that about 22% of assets invested in all U.S. mutual funds are in "world" funds, a category that includes international funds and those that mix U.S. and foreign investments. The total is up from 14% three years ago.

Of course, in addition to rapid appreciation, international stocks have become a larger part of investors' portfolios because new U.S. money has been pouring in as investors chase returns. World mutual funds received larger inflows than domestic stock funds over the past three years, according to the ICI.

The Risks

To be sure, mutual-fund investors have a long history of rushing headlong into recently successful fund strategies, and, buying just as these strategies reach their peak, reaping losses as they fall back to earth.

Emerging markets in particular warrant caution. They are notoriously risky. Few portfolio managers or financial advisers recommend putting more than about 10% of an equities portfolio into emerging markets, so investors might want to think twice about loading up on more than that or even letting their investments grow beyond that point through appreciation.

In addition, all international stocks do carry risks beyond those of domestic stocks. While currency trends have lifted foreign stock values recently, they could quickly reverse.

Thomas Zimmerman, a financial planner in Evanston, Ill., aims to keep clients' international exposure at 17%. While that figure crept into the mid-20s for some less-conservative clients, he recently decided to cut back, citing concerns the dollar could rise.

In a certain sense, U.S. investors already invest substantial amounts abroad when they their put money into U.S. corporations like General Electric Co. and Coca-Cola Co. that have big sales overseas. As a result of expansions abroad, the financial well-being of such companies is tied more and more to the health of foreign economies, says Zachary Karabell, chief economist at Fred Alger Management Inc.

The result is that some U.S. stocks may start to rise and fall in concert with those of foreign companies, rendering one advantage of investing abroad less potent.

Questions:

1. What is the rationale behind the advice to rebalance after successes?
2. When will investing in foreign stocks provide additional diversification?
3. What is home country bias? Do you think it is rational?
4. Is correlation between movements of domestic and international stocks greater during upturns or downturns, or is there no difference? Do some research before you answer this question.