[Ed.: The following post was written by the Wall Street Physician, a radiation oncologist who was an investment bank trader in his former life. He addresses a point of great debate in the finance geek community: Are international stocks another valuable way to diversify, or a tax-inefficient bogeyman out to undermine your investing strategy? Smart people respectfully disagree. This post originally ran in June 2017. I'm pleased to help his voice reach a new audience.]
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, since 1986, the U.S. stock market has gained 10% annually, while the international stock market (developed markets + emerging markets) has returned just 7% 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 32 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.
International stocks are 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 amount of returns lost to taxes (before even selling the index fund) for the Vanguard International Index Fund VTIAX was 1.19%, while only 0.48% was lost in taxes with VTSAX (Vanguard Total Stock Market Index Fund).
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 his holdings — such as Apple, Coca-Cola, and Proctor and Gamble — do significant business overseas. So 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?
[Ed.: Thanks for the insight, WSP.]
Comments 9
I too include international stocks in my portfolio just to give added diversification that you mentioned. I also split the international stocks into emerging and developed markets (possibly overkill, but I kind of like a little bit of gambling on emerging countries).
Stocks right now represent 75% of my investing portfolio. 55% of that is domestic, 20% international.
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Some find the additional slice n dicing of international into subclasses fascinating, and many folks far smarter than I advocate it (Bernstein).
Like you, I have a relatively aggressive portfolio tilted to equities, but I can retain the flexibility to extend my currently far more pleasant work life if things go south. I also have a glide path to reduce my proportion of equities (and the attendant risk) as I near retirement.
I look at my portfolio as having a “stock” component. My portfolio is diversified along non correlated assets. I do not consider emerging classes international classes and domestic classes as providing much in the way of diversification. If US markets hold a correlation of 1 international holds a correlation of .84 and EM is .77 Imagine a circle with a line from the center pointing straight up. This is US. Imagine a line tilted a little bit to the left, this is International. Imagine a line tilting a little more to the right this is EM. Now imagine a line that goes off at right angles to the US vector. This is bonds. During the bull market the 3 upward lines add a little bit of overall growth and possibly if allocated correctly some bit of reduced vol. This is good. What happens when the bear comes? All lines point directly into the ground. The correlations become virtually 1. So you get a little goose on the upside and not much protection on the down. What saves your bacon on the way down is the stored wealth in bonds. Once dowm bonds are a source to rebalance and buy more cheap shares, aka buy low. If you were rebalancing on the way up you would have been adding to bonds by selling high which gives you the store of value to inject money into cheap shares. This is where your power comes from not from near identical correlation.
As I said my portfolio has multiple diverse non correlated assets including alternatives BRK.B bonds and gold. Stocks comprise roughly 60% of my assets and my stock assets are divided into 42% US 14% international 5% EM or 61% equities. My “stocks” get a little boost on the way up but on the way down they all point hard into the ground, but they only represent 60% of my wealth. I have my risk set at about 2/3 of market risk as represented by the volatility of the S&P 500. Setting my risk means when the S&P drops 50% I drop 33%. This means it takes 100% for the S&P to get back to zero while it takes me only 66%. I get back to zero considerably faster and by the time S&P gets even I’m ahead and already compounding. IMHO THIS is the relevant thing to focus on, risk management. 10% or 30% foreign equities is pretty much a waste of time to focus on in the big picture because it represents only a small fraction of net return. In my case 30% of my total equities are foreign, but they represent only 19% of my total portfolio. If I change that to 22% or 16% it doesn’t make any difference to the overall performance except on he margin. I’ll take an appropriate risk adjusted efficient 100% US portfolio every time over some less efficient global portfolio. I think this is what Buffet is saying. In the macro view big stuff makes t a big difference. In my opinion the bogelhead 3 pays too much risk for too little return and would be better off raising the bond percentage and lowering the equity percentage and by rebalancing the foreign/US percentage. I recently published an article over on XRAYVSN that looks at the risk of portfolio failure far in the future for the Bogelhead 3 compared to a 60/40 portfolio. The numbers speak for themselves
https://xrayvsn.com/2018/06/14/guest-post-gasem-a-quantitative-method-to-look-at-retirement-portfolio-risk/
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Gasem,
I think you’ve taken a wise defensive posture that maximizes protection from SORR in your early retirement years. Your guest post on XRAYVSN illustrated how poorly a 3 fund lazy portfolio might fare in a perfect storm scenario.
I’m torn about BRK.B – it’s a well-run, reasonable tool for diversification. I just finished “The Snowball” a couple of months ago on a friend’s recommendation, and it gave me great respect for Buffett the hands-on manager. I vacillate between opting out on the fear that once Buffett and Munger pass the organization will undergo irreversible change, and waiting until that time comes to buy at a discount on the dip.
I bought BRK.B for a number of reasons. It mimics BRK.A though not perfectly. BRK.A is not a trading stock. It is 290K per share right now. Buffet doesn’t split because it promotes not selling. if you own 10 shares you would have to think hard about selling 1. BRK owns whole companies which were purchased at a good value. BRK holds a lot of cash right now because Buffet can’t find anything he wants to buy at the prices people are offering. So if it’s not a good value Buffet won’t over pay. That’s good discipline. I like the internal tax management. Since Buffet doesn’t sell he doesn’t generate cap gains. He also uses the insurance float as a means to internally finance, so it’s like having a bank in your back pocket. BRK doesn’t own tech but it has a good return. This goes to diversity. A portfolio is diversified if you own 20 companies. If you own 1000 it barely moves the needle on improving diversity. My point is the idea diversity is simply piling more and more on higher and deeper is flawed. BRK owns a portfolio of about 65 diversified companies all well run and profitable. This is why I don’t worry about Buffet dying. It’s the 65 well diversified companies that give BRK its value not Buffet. BRK is being managed not by Buffet alone. He has specifically addressed succession planning and has his heir apparent managers ensconced living and breathing the business much like a Fellow lives and breathes his specialty under the watchful eye of his/her famous attendings. After a while the Fellow gets pretty good at understanding both the medicine and how the attendings think about and practice medicine. So to me succession is not a black hole, and BRK is a stock you buy and hold anyway. So I look at BRK as a long term value play well diversified and well managed with succession planning with plenty of cash on hand to scoop companies at the right price. It has little tech exposure which adds portfolio diversity.
Great post Crispy Doc. I know there is some thought that the large US corporations in domestic funds give you all the international exposure you need, but I still think its important to include overseas stocks in any well rounded portfolio.
My own allocation is similar to yours, I’ve got about 1/3 of my total stock exposure outside of the US, but I think there is a wide range of allocations that are reasonable.
Regardless of what you decide, I couldn’t agree more with your last point, its important to choose an allocation and stick with it, rather than chasing returns.
-Ray
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Thanks, Ray, but all credit goes to the Wall Street Physician, who was kind enough to let me syndicate his original post on the subject.
Fondly,
CD
My portfolio is 22% vtiax.
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I’m 80/20, counting 10 in REIT as part of my 80. Of the remaining 70, 2/3 is VTSAX and 1/3 is VTIAX.