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See the World (Differently)

Instead of searching for diversification, investors should go abroad looking for good businesses.

Bridget B. Hughes, 12/11/2007

This article originally appeared in the fall 2007 issue of Morningstar Advisor magazine. Subscribe today. We also value your comments. E-mail us with your viewpoints, ideas, and other feedback.

There's been little argument over the notion that investors should have some foreign exposure as part of their portfolios. Asset allocators and financial advisors have long recognized the benefits of buying international stocks and mutual funds. Indeed, it's been decades since Harry Markowitz, t he father of modern portfolio theory, introduced the idea of the efficient frontier, which suggested that an allocation (10% to 20% seemed to be the standard) to international stocks provided the optimal combination of risk and return.

Back then, though, the purported reasoning behind the inclusion of international stocks stemmed from the benefits of diversification. Overall, risk was lower because when U.S. markets were weak, foreign markets were stronger--or at least providing some ballast to investor portfolios. The fact that global markets behaved differently, over time, helped investors achieve better returns.

But times change, and the diversification argument is becoming harder to make. In today's global economy, borders are blurring, economies are connecting, and what country a company calls home doesn't necessarily say much about where it's making its money. As the world's markets move together, you and your clients may wonder: Is globalization weakening the case for international investing?

We believe the opposite is true. In today's world, more than ever, a healthy stake of international stocks should be an essential part of most people's portfolios. But the reasons for investing overseas are changing. To be sure, there are still diversification benefits to be had, especially in emerging markets and currencies. The better arguments for going abroad, however, are that many of the world's great investment opportunities are overseas and that is where many of today's top investors ply their trade.

Mimicking Markets
Investors can no longer count on the conventional thinking that an international stake will automatically diversify their portfolio. Correlations between the S&P 500 Index and the MSCI EAFE Index are higher today than they were 20 years ago. And over the past five years, the typical foreign large-growth and large-value funds weren't any more volatile than their domestic counterparts, suggesting that investing overseas doesn't require investors to take on more risk than they would by investing domestically.

Also, markets tend to act more like each other in times of stress and excess--precisely when investors most need diversification. The correlation between the S&P 500 and the MSCI EAFE spiked dramatically twice during the past 20 years. The first period included the stock-market crash of 1987; the second when large-cap stocks were soaring to precarious levels in the late 1990s and the subsequent bear market. In the past couple of years, the U.S. stock market has reacted twice to short-term market disruptions in emerging markets, including its swoon early this year when China's market fell 10% in a single day.

Problems in the United States are causing similar effects overseas. Markets around the globe, including Japan's, were affected recently by worries about the U.S. subprime crisis and its ripple effects stateside. Mark Headley, manager of Matthews Pacific Tiger MAPTX, told us recently that he worries most about a U.S. recession and the effect it would have on Asian markets.

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