Thursday, March 08, 2007

Diversifying into International Markets

My personal asset allocation goal is to keep approximately 25% of our assets in international stocks. With the recent correction in many of the international markets, I think that now may be a good time to slowly increase exposure to this asset class.

To make it clear, I don't advocate playing the Chinese stock market, nor dumping your nest egg into Brazilian penny stocks. While I believe that emerging markets offer some attractive opportunities in the long run, many emerging market stocks have seen oversized returns in recent years, and may be ripe for some bumps and bruises. No, when I talk about investing in international stocks, I am talking about indexing. My chosen international index is Vanguard's Total International Stock Index (NASDAQ: VGTSX). I picked this fund for its broad diversification: it holds shares in Vanguard's European, Pacific and Emerging Markets indexes, which together give me exposure to much of the global economy.

I am a proponent of international investing for a number of reasons: first, international diversification helps to mitigate single country risk. For example, if the U.S. economy falls into recession, it is likely that other global economies will continue to chug along, thus dampening the impact of U.S. stock market declines on our portfolio.

Second, it is well established that emerging market economies tend to grow at a faster rate than those of developed countries. Companies that invest in those economies have a better chance of seeing a faster profit growth and faster stock price appreciation. Of course, emerging markets are a higher risk investment as they are more prone to cycles of boom and bust (remember the Russian default? the Thai economic meltdown? etc.)

Third, with the growing trade deficit and with the Federal budget deficit, I think it likely that the dollar will continue to decline against world currencies. By investing in foreign stocks, or at least in companies that obtain much of their income in foreign currency, I am protecting us against the adverse effects of a weak dollar. As the dollar falls, an investment denominated in foreign currency will be worth more in USD.

I believe that any well balanced portfolio should contain a healthy dose of international diversification. However, it is important not to over do it, since with the potential for higher returns come bigger risks and a potential for some additional sharp corrections after the rapid stock price increases in recent years. Additionally, if you are thinking of investing in international markets, make sure you are doing it for the right reasons. That is, do not try to chase hot international funds in the hope (or delusion) of striking it rich. Rather, if you invest internationally, do so for the added benefits of diversification and exchange rate risk protection, and be prepared for what may be a bumpy ride.

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