Don’t put all your eggs in one basket.
You’ve probably heard many people tell you this, from your mom to Jim Cramer to folks writing on physician personal finance blogs. That’s why the S&P 500 and U.S. total stock market index funds are the largest mutual funds in the world.
People know the importance of diversification and for good reason: it’s one of the few free lunches on Wall Street.
The problem with investing in only an S&P 500 or total stock market index fund is that while the United States may feel like the center of the universe, the international economy is very large.
In fact, half of the world’s market cap is located in companies outside the United States.
That’s why the 3-fund portfolio has become so popular. By having money in U.S. stocks, international stocks, and U.S. bonds, you have diversification in not just the U.S. economy, but the world economy.
But how much international stocks should a three-fund investor have in their portfolio? It’s not an easy question. Here’s why.
Historical Returns of U.S. vs. International Stocks
According to Portfolio Visualizer, from 1986-2018, the U.S. stock market has gained 9.9% annually, while the international stock market (developed markets + emerging markets) has returned just 6.6% annually. But in any given year, international stocks may outperform U.S. stocks or vice versa. In fact, despite its overall under-performance, international stocks have outperformed U.S. stocks in 15 of the past 33 years.
The Case For International Stocks
Using historical returns of the S&P 500 and EAFE index, you can build an efficient frontier of various asset allocations between U.S. and international stocks. Over the time period 1970-2008, it turns out that an 80% U.S. / 20% international portfolio had a higher return, with lower risk, than a 100% U.S. / 0% international portfolio.
Over this same time period, the asset allocation with the maximum return was a 50% / 50% U.S. / international portfolio.
Remember that these returns are achieved even though international underperformed domestic stocks over this time period: a 100% international / 0% U.S. portfolio had the lowest return and the highest risk. That’s the power of diversification: because the U.S. and international stock markets do not move in lockstep with each other, you can improve your returns and reduce your risk by adding international stocks.
Of course, past performance is not indicative of future returns. You should not try to optimize your portfolio based on an efficient frontier built on past returns. For example, according to a Bogleheads analysis, the optimal portfolio of U.S. / international asset allocation has varied depending on the decade you are studying. The optimal portfolio in the 1970s was 70% domestic / 30% international, while in the 2000s, it was 100% domestic / 0% international.
The Case Against International Stocks
International stocks are more expensive to own than U.S. Stocks
International stocks have slightly higher expense ratios than U.S. index funds, but the difference is typically only a few basis points (a basis point is equal to 0.01%, or $1 per $10,000 invested). For example, Vanguard’s Total International Stock Index Fund (VTIAX) has an expense ratio of 0.11%, while their Total Stock Market Index Fund (VTSAX) and S&P 500 Index Fund (VFIAX) each have expense ratios of 0.04%. So the difference in fees on a $1 million portfolio is $700 per year.
International stocks may be less tax-efficient than U.S. stocks
International stock funds are less tax-efficient that U.S. stock funds. Some of this has to do with the higher dividend yield of international index funds, and some has to do with the inefficiencies of managing a portfolio invested in the less-liquid international stock markets. For example, over the past 5 years, the potential amount of returns lost to taxes (before even selling the index fund) for the Vanguard International Index Fund VTIAX was 0.91%, versus 0.63% for VTSAX (Vanguard Total Stock Market Index Fund), according to Morningstar’s Tax Analysis tool for ETFs and mutual funds.
Of course, you do get some tax benefits with international stock funds, such as the foreign tax credit. And by placing international stocks in a tax-deferred or retirement account, you are not hurt by international’s relative tax inefficiency.
International Stock Asset Allocation: Three Different Approaches
No International Stocks
Warren Buffett does not recommend international stocks to ordinary investors. He has previously recommended us to “Buy American.” In his 2013 annual letter to shareholders, he suggested a portfolio of 90% S&P 500 and 10% short-term government bonds to investors.
Of course, many of the holdings in Berkshire Hathaway — such as Apple, Coca-Cola, and Proctor and Gamble — do significant business overseas. Many of the factors that influence the movements of international stocks — currency markets, European macroeconomics, and global unrest — affect the prices of his U.S. based holdings as well.
Jack Bogle also recommends against international stocks in his portfolio. His rationale is a global macroeconomics argument. He has a firm belief that the U.S. economy will continue to outperform the global economy in the future. For example, in an interview with Morningstar’s Christine Benz, Bogle argued that each of the major countries in the EAFE international index have significant economic headwinds. Compared to Europe’s and the rest of the global economy, the U.S. economy looks pretty good in Bogle’s eyes.
Market-Weight International Stocks
Another approach would be to have a market-weight allocation of international stocks. Since only half of the world’s market cap is in U.S. based stocks, that would mean that a market-weight asset allocation would be 50% U.S. / 50% international stocks.
This is the purest way to own the global (U.S. + international) stock market. Any other allocation would be overweight or underweight international stocks.
Over-Weight International Stocks
A small minority of investors believe you should be over-weight international stocks. These people would have a bearish view on the U.S. economy. They believe that international stocks will outperform U.S. stocks in the future and a portfolio overweight in international stocks would outperform a more balanced portfolio.
These people also might argue that you should not put 50% or more of your portfolio in a single economy, even if it is the largest, greatest economy in the world. Some people point to the example of Japan, which peaked in 1989 and has had negative 30-year returns. It would not be good if the U.S., as great as it is now, were to have Japan-like returns in the future.
My Personal International Stock Allocation
I see the diversification benefit in international exposure, but am not comfortable with a fully market-weight international stock allocation. My stock allocation is 2/3 domestic, 1/3 international. This happens to be between the international allocation of Fidelity’s target-date funds, which are 70% domestic, 30% international, and Vanguard’s target date funds, which are roughly 60-40. Based on historical data, this allocation would lead to the lowest risk portfolio, but I am not expecting future stock returns to align with its past performance.
Whatever asset allocation you pick, stick with it. The worst-case scenario is to increase your international allocation when international stocks are doing well (e.g. in 2017), and reduce your overseas exposure when the U.S. is outperforming. Because there are so many good arguments for any international allocation, it’s easy to cherry-pick your allocation based on what’s popular at the time.
What do you think? What is the international stock allocation of your portfolio?
I’m in the same boat as you, with slightly more (but not quite 50%) international exposure. I don’t think there is any “right” answer, just what feels comfortable.
As a side note and a whole different discussion, I still have not added international bonds to my portfolio, but I periodically revisit the topic every 6-12 months or so to see what the talking heads on Bogleheads and elsewhere have to say.
For younger investors who may have only 10-20% of their portfolio in bonds, international bonds becomes such a a negligible part of their portfolio that it’s probably not worth adding a 4th fund.
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I am surprised you are using target date funds. Can I ask why? Maybe that would be a good up coming post.
I have some international exposure 10% in my 401K. My IRAs are straight S and P 500 index funds and receive whatever international exposure American Companies have.
I do not use target-date funds – my international allocation just happens to be between that of the target date funds of Vanguard and Fidelity.
I sit at about 20 percent international. Honestly past performance doesn’t equal future returns. Just because International has lagged domestic historically doesn’t mean the category should be shunned. Also given many large cap internationals do business in multiple countries, the currency exposure is probably overblown imho. Is my companies international competitor with similar regional business makeup any more risky then my own company?
As the efficient frontier from the Bogleheads wiki showed, you can get a higher return with lower risk even if international underperforms.
Similar to you, my stock allocation is 3:1 domestic : international. Diversity is a good thing.
Cheers!
-PoF
Glad to see we share similar asset allocations.
-WSP
2:1. He said he had 33% or 1/3rd International. So he has 67% (2/3) U.S. That is 2:1 U.S. to Intl, not 3:1. 3:1 would be 25/75.
I’m around 25% international exposure. I have no idea if that’s best. It’s midway between 0% and 50%, so if either extreme turns out to be correct, I’ll partially benefit. Thanks for the great post!
Seems reasonable to me — there’s no perfect international allocation.
I’m around 20% – recently had a similar similar analysis of my own asset allocation and saw that they have been a drag on my portfolio for a while. I’m keep it as is right now but may make some changes eventually.
International stocks may seem like a drag right now, but they may (or may not) outperform domestic stocks in the future.
We are pretty similar, around the 25% international equities.
Thanks for sharing your allocation.
I stuck with emerging Markets for the last few years and got crushed! But this year up 35% ytd. Not sure that says anything other than stocks are volatile,and EM doubly so. Currency plays such a big effect and will probably continue to do so,with the current administration.
But I’m with you – about 30% target
EM is much more volatile than developed international. If possible, you can use an index fund that gives exposure to both developed and emerging markets within a single index fund. Both Vanguard and Fidelity have these types of funds.
I have 27% of my equities in international today. Informative post. I think you did a great job looking at all the alternatives and providing the pros and cons of each.
Thanks Jason for the kind words.
Everything is so interconnected from a global perspective that I think the separation between markets in different countries is much more muted than it was even 25 years ago. I really don’t think you’ll run into too many situations where, for example, US stocks are tanking, but another country is going to be rocketing up. Everything’s too intertwined now.
Correlation between domestic and international stocks may be increasing, but it is certainly not 1.0, which means there is benefit to diversification to international stocks.
Mine is 15% of my portfolio right now, mostly in the fund I can access through my employer which is established markets. I got to spend three months in Kenya a few years ago and it really opened my eyes to the potential of emerging markets. Just don’t have a great way to invest in them at the moment.
There are many emerging markets index funds available. Emerging markets often have slightly higher expense ratios than developed international or total international funds. Country-specific funds are also available, but they often have much higher expense ratios than the big international index funds.
Both markets have done very well this year, US and foreign. Since the PE for the US market is now roughly twice that of the international market, I think this is justification for increasing moderately (from 40% to 45% foreign) the foreign stock percentage.
That’s a reasonable thesis, but tweaking your asset allocation based on valuations puts you at risk of market timing.
Very informative article, I’m glad to have the opportunity to read about all of the summarized studies. We have about 30% of our stock allocation in foreign stock funds. A aspect of this allocation question that I think deserves more attention is when and how to adjust or rebalance your allocation. I like your advice to stick with a plan–especially in contrast to trying chase winners or time markets. But over time an allocation almost inevitably gets out of balance–70/30 may end up as 80/20 or even 90/10. It’s tempting to let your winning investments ride, but you can’t buy low and sell high unless you trim your winners to buy more of your losers. How and when would you rebalance? And would you necessarily return to the same initial balance, say 70/30, as opposed to going with an adaptation of that, say 75/25 or 65/35 depending on circumstances?
I effectively rebalance every month when I move money into my taxable account. I’ll contribute more or less to each funds to maintain the balance.
Owning foreign funds is NOT necessary since foreign sales as a percentage of total S&P 500 sales is over 40%. If you own the S&P 500 you are already investing in the entire world.
I have 0% international at the moment – more in line with Buffett and Bogle. I’ve been on the fence with this, since I realize diversification is a good thing. This article helps a lot as I think more about this, especially the link to the portfolio visualizer – thank you!
Currently sitting at around 33% international. As one ages should the international allocation stay at 33% or should it lower to a more conservative %?
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What percentage of international equity allocation should be emerging markets? And what about small and mid cap international?
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