Column by Jim Flinchum, CIMA, CFP - The Virginian-Pilot, July 23, 2006

Most every investor has heard about the importance of asset allocation, which refers to the percentage of your portfolio invested in various asset classes, such as stocks, bonds, cash, real estate and so forth. Several studies have indicated that this is the single most important factor in your overall long-term investment performance. In fact, most investors have probably been told this many times. But, once you have decided how much to allocate to stocks, how much should you allocate to US stocks and how much to non-US stocks? Globalization requires us to re-think this.

Reading the newspaper makes it clear that the world outside America is a scary place. Referring to the hugeness of the U.S. stock markets, Warren Buffet said “If I can’t make money in a $5 trillion market, it may be a little bit of wishful thinking to think all I have to do is get a few thousand miles away and I’ll start showing my stuff”. So, it is not surprising that investment advisors have been reluctant to recommend international investing opportunities to their clients, for fear of appearing imprudent or overly-aggressive.

Yet, in his most recent book, The Future for Investors, Dr. Jeremy Siegel said “To ignore the foreign markets would be akin to forming a domestic portfolio filled only with firms that begin with the letters A through L.” He makes a good point. The U.S. only has 52% of the world’s equity markets. Should we pay no attention to the other 48%? Other respected writers argue the US only has 35% of the world’s equity markets, and we are ignoring two out of every three investment opportunities. Whatever our current share of the world’s stock market values, all agree the US share is decreasing. Globalization is changing many things, including the world of investing.

Better returns are available to international investors. According to academician Dr. Bruno Solnick, equity returns in the US have averaged 8.81%, compared with 9.84% abroad and with similar volatility or risk. Second, because international markets often behave differently than ours, the lower correlation to our markets tends to lessen the volatility of the overall portfolio. The most widely-held investment school of thought today is Modern Portfolio Theory, which tells us that overall portfolio risk is decreased, and return is increased, by adding some exposure to the international markets.

Getting exposure to the international markets in your portfolio is obviously more difficult than getting exposure to the US equity market. We know US companies, like Bank of America or American Airlines, but very little of foreign companies. Most investment advisors encourage their clients to invest by means of an international mutual fund, where more knowledgeable professionals make the individual stock selections. The bad news is that the annual fees for international mutual funds are almost always more expensive than US mutual funds.

More recently, exchange-traded funds (ETFs) have become very useful in gaining this exposure and are usually cheaper. You can simply invest in the broad international market or in regions, such as Latin America or the Pacific Rim countries. You can invest in the stock markets of particular nations, like Mexico or Japan. You can use these to implement specific objectives. For example, if you think the future lies in commodities, you can buy an ETF of commodity rich nations like Canada and Australia. There are many ways to utilize these convenient vehicles to increase your allocation to international investments.

You may not like globalization. You may even be frightened by it. But, it is happening anyway, and the world of investing is now fundamentally different. A portfolio cannot be protected by ignoring it. Thinking small in a bigger world is expected to be costly.

Jim Flinchum is a Certified Financial Planner practitioner and a Certified Investment Management Analyst.