Foreign investing adds vital diversification

Through the late 1990s American investors liked to stick close to home. They were well rewarded for doing so—the Standard & Poor’s 500 index returned 16.8% on average yearly, while the Morgan Stanley EAFE Index, a gauge of large foreign stocks, had an average annual return of just 8.8% per year.

But that is history. It is time for rational investors to look at the diversification advantages they may gain by putting some of their money overseas. Investment research indicates that a portfolio of assets whose return patterns are not closely correlated will be less risky than any of its components. It also may offer higher long-term returns than any of its components.

Critics of international investing in recent years have argued that the globalization of the world’s economy has increased the correlation of international and U.S. stocks, reducing the advantage of investing overseas. While the correlations have increased, they still don’t move in lockstep, argues a study by State Street Research and Management Co. in Boston. The correlation of EAFE with the S&P 500 grew from 0.47% in 1991 to 0.65% in 2001. While smaller, it appears there is still a diversification advantage to overseas investing.

Investors can increase their diversification by using small international stocks and emerging markets stocks. Both offer very different return patterns from EAFE, which mainly covers the largest stocks in Europe, Australia, and Japan. Small stocks issued by companies in developed international markets have a very low correlation with the S&P 500, says Michael W. Gerding of Denver Investment Advisors. The correlation figures suggest that “these stocks take few if any cues from the movements of American markets,” he writes in the Journal of Financial Planning. “As such, this asset class may be ideal for diversifying an equity portfolio away from the influence of the domestic large-cap stock market.” Emerging market stocks have even lower correlations with those of developed markets. However, their volatility is higher. Investors should control the higher risks of both small international and emerging markets stocks by combining them with more stable asset classes, such as large U.S. stocks and bonds.