International stocks can help dampen your portfolio’s risk

Foreign stock markets were on fire last year, handily beating the U.S. market and drawing the attention of domestic investors. The Brazilian stock market gained 44%, Germany 22%, China 96%, and India47%. The U.S. market, as measured by the Standard & Poor’s 500 Index, gained just 3.5%. And that was not an isolated, one-year event: foreign stocks on average have outpaced domestic stocks over the last five and 10-year periods. Some investors undoubtedly will begin chasing those returns, but is that the reason to invest internationally?

Those investors miss the key reason for international investing – reduction of risk through diversification, says Karen L. Lewis, a finance professor at theWhartonSchool. Despite the globalization of world financial markets, international stocks still offer a significant diversification benefit, she found in a recent academic study. Foreign stocks still move differently enough from U.S.stocks that their inclusion in a portfolio helps to dampen its volatility. “The bottom line is that there still are benefits to international diversification in 2007 and 2008,” Lewis says.

Conventional wisdom has held that international stock market diversification has diminished as it has become easier for investors to put their money anywhere in the world. But Lewis says her research showed that over the past 20 years – the covariance between foreign markets and the has increased only slightly? and that the volatility of foreign markets has actually declined. She says a U.S.investor can reduce the volatility of a portfolio by 15% by mixing in foreign stocks. To do this it takes a foreign stock allocation of about 20%, she says.
She warns that investors can’t get the same diversification by using American Depository Receipts – foreign stocks that are listed on U.S. exchanges. “The diversification properties of (ADRs) are inferior to investing in foreign markets directly,” she concludes.