If you’re an American, is investing in the U.S. stock market good enough on its own? Or do you need to invest in international stock markets as well?
Which route leads to better returns? Which involves less risk? What are the pitfalls to avoid? And if international investing is worth it, how much of your money should you keep abroad?
In this post we’ll dive into all of that, exploring the pros and cons of international investing to help you figure out whether it’s right for you.
Pros of Investing in International Stocks
Diversification is a fancy sounding word, but all it really means is that you benefit from not having all your eggs in one basket.
If all of your money is invested in one company, your returns are completely tied to the fortunes of that company. But if you spread your money out over 1,000 companies, even a few bad apples won’t hurt you.
In fact, diversification is the one free lunch in investing. It’s the only way to decrease your investment risk without sacrificing any expected return.
And adding international stocks increases your diversification. You’re simply invested in more companies in more places, which means you’re more likely to have the best-performing companies in your portfolio and the worst-performing companies will have even less of an impact.
There are certain risks that are specific to international stocks, but when combined with U.S. stocks there’s a good chance that they will decrease the amount of investment risk you face.
Vanguard published a paper in 2012 that looked at several aspects of international investing, and one of the things they found was that a global portfolio was less volatile than holding either U.S. stocks or international stocks alone.
While there’s no guarantee that trend will continue, if it does then it means that including international stocks in your portfolio makes for a smoother ride. There will still be plenty of ups and downs (there’s no way to remove that completely), but they won’t be as large as if you hold only U.S. stocks.
Potential Rebalancing Bonus
Because the markets are constantly moving, over time your investments will drift away from your target asset allocation. Rebalancing is the process of bringing your portfolio back in line with your original plan.
It’s a good practice that leads to better risk-adjusted investment returns. But for the most part it leads to slightly lower absolute returns, simply because it means you’re regularly selling the investments that are performing best in exchange for the investments that are performing worse.
However, when you have two investments that provide similar returns but rise and fall at different times, rebalancing between them can actually produce a higher return with less risk than either of the investments on their own (see here for the math).
Since U.S. stocks and international stocks have similar expected returns, but usually will not move in lockstep, having both in your portfolio and rebalancing between them creates the possibility of better returns with less risk. And who doesn’t want that combo?
With that said, the correlation between these two investments has increased recently, and that dampens this effect. And since we can’t predict the future, there’s no guarantee that this will continue to be a benefit.
Cons of Investing in International Stocks
In general, it’s more expensive to invest internationally. For example:
- Vanguard’s Total U.S. Stock Market Fund (VTSAX) costs 0.05% to own each year.
- Vanguard’s Total International Stock Market Fund (VTIAX) costs 0.12% to own each year.
In that example, the difference is small, though present. In other situations it can be more significant. I often review 401(k)s that offer an extremely low-cost U.S. stock market fund, but only a mid- to high-cost international stock market fund.
Since cost is the single best predictor of future returns, this is an important factor to consider. At a certain point the extra fees will outweigh any potential benefit.
While the financial industry would have you believe that good investing is complicated, the truth is that the best investment plans are often the simplest.
“Everything should be made as simple as possible, but not simpler.”
– Albert Einstein
Adding international stocks introduces one more piece of your portfolio you have to track, understand, and believe in. If the additional complexity makes it harder to stay organized and stick to your plan, it may actually lead to lower returns.
On the other hand, the existence of all-in-one investments like target date retirement funds can make it easy to invest in international stocks and still keep things very simple. If that works for you, then this point is moot.
How Much Should You Invest in International Stocks?
If you want to invest in international stocks, how much of your money should go there?
The first task is to decide on your overall asset allocation. What percentage of your investments do you want in stocks in general, versus more conservative investments like bonds?
Then you can look at just the stock portion of your portfolio and decide how much of it you want in international stocks versus U.S. stocks.
Vanguard’s research suggests that a minimum of 15% of your stocks should be invested internationally, with the maximum based on global market capitalization. According to the MSCI All World Index, 47% of the global market is outside the U.S., so that would set your cap.
Personally, I split my stocks 50/50 between U.S. and international, because it’s simple and it’s close enough to the actual ratio.
To decide for yourself, consider first whether the complexity is worth it for you and what you’re comfortable with. Then look at the options available to you. If your 401(k) doesn’t have good international options, it may not make sense to force it. You could always balance it out with your IRA — but again, managing that complexity might do more harm than good.
On the other hand, maybe you have good, low-cost, all-in-one funds or target-date funds available to you that make it easy. In that case, you don’t even have to worry about the percentage since it will be handled for you.
In the end, investing in international stocks can certainly produce some benefits, possibly in the form of better returns with less risk. But there’s no guarantee, and there’s certainly no right answer. So feel free to do what’s both comfortable and easiest for you.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.