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Investing Specialists

What's the Right Foreign Allocation?

Understand how to go global without going out on a limb.

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Note: This article is part of Morningstar's December 2014 Guide to Better Investment Picking special report. An earlier version of this article appeared in November 2012.

Foreign-stock funds have generally performed less well than U.S. over the past several years, but investor fund flows have bucked the trend. Whereas we often see investors lavish attention on the categories that have performed exceptionally well, investors have actually continue to add money to foreign-stock funds amid the weakness.

It's hard to say why this might be so--after all, investors as a group have a wide range of motivations and experiences. But one guess is that many investors have decided that their portfolios are too beholden to the fortunes of the U.S. economy and market, so they've decide to diversify.

But what's the right allocation to foreign stocks? There are no hard and fast answers. Even informed observers vary widely on how much to stake overseas, ranging from the "don't bother" camp to the "all global, all the time" school of thought.

And importantly, classifying foreign and U.S. companies based on where their headquarters are located is evolving into an increasingly questionable exercise, especially for large-cap multinationals. Companies such as  Coca-Cola (KO) and
 McDonald's (MCD) derive more than half of their revenues from overseas, whereas global behemoths such  Nestle (NSRGY) and  Toyota (TM) count on the U.S. for a big portion of their sales.

The Global Portfolio: A Starting Point
Given the fact that country of domicile doesn't say a lot about where a company actually does business, it's tempting to shelve the foreign-versus-U.S.-allocation question altogether and simply opt for a global-markets index fund such as 
 Vanguard Total World Stock Index (VTWSX). That fund apportions its assets by market capitalization and lets the largest companies fall where they may. As of its most recently available portfolio, the fund's top 20 holdings included
 ExxonMobil (XOM) and  Apple (AAPL) as well as Nestle and Novartis (NVS).

That's a logical approach, particularly for those who are already index enthusiasts. If you buy into the concept of letting the market decide the size of the holdings in your fund, letting the market decide country weightings is a logical extension of that thought process.

And even if you're not ready to cede complete control of your country allocations by investing in a global stock market index fund, the geographic allocations of the global market provide a good starting point for thinking about your own allocations. As of midyear, the FTSE All-World Index staked about half of its assets in foreign stocks while the rest were stateside.

Ask the Experts
Morningstar's Lifetime Allocation Indexes, developed in conjunction with asset-allocation specialist Ibbotson Associates, provide additional intelligence about what's a reasonable foreign/domestic split.

In general, it's worth noting that these benchmarks are much less foreign-stock-heavy than is the case with global-market benchmarks such as the FTSE All-World Index. For example, the portfolios geared toward investors who are just starting out steer roughly 40% of their equity assets toward foreign stocks, and those weightings step down dramatically for those nearing and in retirement. For people with 10-15 years until retirement, the indexes' foreign stakes compose roughly 30% of the overall equity allocation and drop to 20%-25% of equity for those who are already retired.

One of the key rationales for a lower foreign-stock allocation in retirement is currency risk. Because foreign assets are not denominated in dollars, there's a chance that foreign currencies could dip as an investor approaches retirement, thereby depressing the purchasing power of a heavily globalized portfolio at an inopportune time. Of course, those currency swings can work the other way, too. But the bottom line is that currency risk is a wild card that's completely out of your control, and you're better off reducing any such risks as retirement draws near.

A checkup of target-date funds' average foreign allocations yields weightings that are in a similar range, roughly one third of the overall equity portfolio. As is the case with Morningstar's Lifetime Allocation Indexes, foreign stocks consume a larger share (close to 40%) of the equity portfolios for younger investors than is the case for investors closing in on retirement. 

See More Articles by Christine Benz

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.