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Rightsizing Your Foreign-Stock Allocation

When should this be done?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Investors often adjust their stock/bond mixes at year-end or the beginning of a new year to restore balance to their portfolios. But Morningstar's director of personal finance, Christine Benz, suggests that investors go one step further and take a good look at their non-U.S. stock allocations. She is here today to discuss the topic.

Hi, Christine. Good to see you.

Benz: Hi, Susan. It's great to be here.

Dziubinski: Now, before we get into talking about asset mixes when it comes to foreign stocks, let's first talk a little bit about the performance of non-U.S. stocks. They didn't do particularly well in 2020, and they have lagged for a little bit of time. So, what's the case for non-U.S. stocks today?

Benz: Right. Viewers are probably watching me saying, "Oh, here she is banging this drum again." The big case is that these things tend to move in cycles. But you're right, Susan, the U.S. market has returned like 14% on an annualized basis over the past decade, whereas poor foreign stock investors have gotten just about 5% annualized over the past decade. That's an enormous differential. So, it's certainly been hard to keep the faith.

The key reason I would say, though, to sit tight is that we do typically see these things move in cycles. Back in the '00s, for example, which feels like a distant memory, foreign stocks actually outperformed U.S. And valuations look a bit more attractive today. I typically do these surveys of investment firms of their capital markets' forecasts to affirm they have been calling for higher returns from foreign stocks than U.S. over the next decade. Another factor in favor of foreign stocks, especially for dividend-hungry investors, is that yields tend to be a little higher, and there are simply some great companies domiciled outside of the U.S. So, those are some reasons that you want to stick tight, but I know it has been a pretty trying period.

Dziubinski: As a first step, if investors want to get their arms around what their current allocation is to non-U.S. stocks, how should they go about that?

Benz: They could start by looking at their dedicated foreign stock holdings and tallying them up as a percentage of their total portfolios. That's not a bad starting point. But I really love our X-Ray functionality on Morningstar.com for getting a window into your portfolio's actual foreign stock exposure. So, X-Ray will actually look into U.S. holdings, for example, and take into account any non-U.S. holdings in their portfolios. And that's particularly common in the value side of the style box among U.S. funds. Some of those funds might be more inclined to hold foreign stocks. So, it's a more holistic view of a portfolio's exposure. It's a really great way to see where you stand with respect to your foreign stock allocation.

Dziubinski: Now, if investors are trying to determine, "OK, what should my target non-U.S. stock allocation be?" how should they be thinking about that?

Benz: It's an important question. A starting point might be to look at some sort of a Total World Stock Index. So, if we look at Vanguard's World Stock Index, which combines all major U.S. and non-U.S. stocks together, it's about 60% U.S. today, 40% non-U.S. That's a starting point. Some investors might not be so comfortable holding such a hefty foreign stock allocation. When you look at professionally managed asset allocations, you typically see a somewhat lower allocation. As a percentage of total equity exposure, 25% to a third of the portfolio is a more common allocation. You can use those benchmarks to get your arms around whether you are holding enough overseas. Many investors obviously have been inclined to sit tight with their U.S. stock holdings because they have outperformed. If you haven't taken a look at this recently, you may want to do a little bit of adjustment. You may not want to change your overall equity exposure, but take a look at that geographic exposure because many investors' foreign stock allocations probably could use some topping up.

Dziubinski: Christine, for investors who are getting closer to retirement, how should they be thinking about their non-U.S. stock allocation relative to the rest of their equity allocation? Should that be coming down as they approach retirement?

Benz: Potentially so. This is certainly the topic of debate in asset-allocation circles. Some firms employ a static U.S.-non-U.S. ratio throughout the investors' lifecycle. Other firms like Morningstar Investment Management would actually tend to downplay foreign stocks as the years go by, as the person gets closer to retirement. And the reason is that the retiree is going to spend his or her portfolio in dollars, most likely, assuming it's a U.S. investor. And so, we'd want to remove the wild card of foreign-currency fluctuations from the portfolio's risk/return profile. But there's a variation in thought there. My thought is, though, retirees, regardless of their risk profile, should maintain at least some exposure to foreign stocks, mainly because I think over the next decade, next couple of decades, foreign stocks may well have better returns than U.S. stocks because the starting valuations look better today.

Dziubinski: It sounds like a little bit extra added to our year-end or beginning-of-year portfolio to-do list, but it sounds like it's important. Thank you for your time, Christine. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.