Do international investments really add diversification benefits to a portfolio? The primary objective of diversification is to reduce the volatility in your portfolio. For instance, when the U.S. stock market is declining, investments in other parts of the world may be increasing. Over the short term, especially during periods of crisis, stock markets throughout the world tend to move in the same general direction. But over the longer term, stock markets tend to be less correlated, with individual markets still responding primarily to their local economy.

One way to determine the diversification benefits of adding an asset class to your portfolio is to review the correlation between the two assets. Correlation is a statistical measure of the extent to which one asset class moves in relation to another asset class, ranging from +1 to -1. A correlation of +1 means the two asset classes are highly correlated and move very closely together in the same direction. Combining assets with a high positive correlation will not provide much risk reduction. A correlation of -1 indicates the assets move in opposite directions, a rare event in the investment world. A correlation close to 0 means no relationship exists in the price movements of the two assets. Combining assets that aren’t highly correlated can help reduce a portfolio’s volatility.

A recent study reviewed the correlation of various asset classes over the period from 1970 to 2004 (Source: Journal of Financial Planning, February 2006).* The study found that correlations have increased in recent years. For the period from 1970 to 1997, the correlation between international investments and the Standard & Poor’s 500 (S&P 500) was 0.48, but increased to 0.83 from 1998 to 2002. The correlation between emerging market investments and the S&P 500 increased from 0.45 during the period from 1988 to 1997 to 0.75 from 1998 to 2002. In the eight down years for the S&P 500 during the period from 1970 to 2004, international investments outperformed the S&P 500 in four years and underperformed in four years. While no one knows whether these correlations will stay high, the increasing globalization of trade makes this a realistic assumption.

Another study found that while correlations have increased in recent years, those correlations tended to stay fairly level over long investment periods (Source: Financial Planning, November 2005).** For instance, one-year correlations between the S&P 500 and the EAFE were 0.74 in 1974, dipping to 0.25 in 1996, but started increasing again in 1998, reaching 0.90 in mid-2005. However, using 10-year rolling periods, the correlation was 0.70 in 1979, decreased some in the mid-1990s, but recently was at 0.70, the same level as 25 years ago. Thus, for investors with long time horizons, international investments still provide diversification benefits.

Do returns in foreign markets offer greater potential than U.S. stock market returns? No one can predict the future performance of any stock market. However, reviewing past performance can help develop realistic expectations. International investments outperformed the U.S. stock market for five-year rolling periods from 1974 to 1982 and from 1985 to 1990. From 1990 to 2003, international markets lagged the U.S. stock market. The year 2004 was the first year since 1990 that international markets outperformed the U.S. stock market (Source: The Case for Global Investing, 2005).

These returns, however, compare overall international returns to U.S. returns. For the 20-year period ended December 31, 2004, 13 different countries had higher average total returns than the S&P 500 (Source: The Case for Global Investing, 2005).

With international investments lagging behind U.S. investments for such a long time, there may be opportunities to find investments in other parts of the world that are more attractively priced than those in the U.S.

Does international investing offer other advantages? The U.S. stock market now represents only 49% of total market capitalization in the world, down from 66% in 1970 (Source: The Case for Global Investing, 2005). Limiting yourself to U.S. investments means eliminating over half of the world’s investments from consideration. In a number of industries, the world’s leading companies are not U.S.-based. Of the top 10 industry leaders in terms of market capitalization, the following were located outside the U.S.: 9 in electronic equipment, 8 in metals and mining, 8 in oil and gas, 8 in wireless telecommunications, 7 in automobiles, 7 in commercial banks, 7 in electric utilities, 6 in beverages, 6 in insurance, and 5 in pharmaceuticals (Source: The Case for Global Investing, 2005). Also, since different countries are at different developmental stages or at different stages in the economic cycle, you may find opportunities to invest in trends in other parts of the world that you missed in the United States.

What percentage of your portfolio should be invested in international investments? It is usually recommended that you allocate at least 10% of your portfolio to international investments, since less than that will typically have little effect on your portfolio’s total return. However, what percentage you allocate will depend on personal factors, such as your risk tolerance, time horizon for investing, and comfort level with foreign investments. International investing may not be suitable for everyone. In addition to the risks associated with domestic investing, foreign investing has unique risks, such as currency fluctuation, political and social changes, and greater share price volatility.

* The study used the returns of the Standard & Poor’s 500 (S&P 500) for U.S. stock returns, the Morgan Stanley Country Index for international returns, and the Morgan Stanley Emerging Markets Index for emerging market returns. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot directly purchase an index. Past performance is not a guarantee of future returns. This information is presented for illustrative purposes only.

** This study used the returns of the S&P 500 for U.S. stock returns and Morgan Stanley’s EAFE (Europe, Australasia, Far East) index for international returns. The EAFE Index is an unmanaged index of foreign stocks generally considered representative of stock markets outside the U.S.