Ask an advisor: What's the right ratio of U.S. and foreign stocks?

Ask an advisor: What's the right mix of U.S. and foreign stocks?

April 13, 2023 6:13 PM

Investing in both American and foreign stocks is a popular way to diversify one's portfolio.

Welcome back to "Ask an Advisor," the advice column where real financial professionals answer questions from real people. The topic can be anything in the world of finance, from retirement to taxes to wealth management — or even advice on advising.

Almost any wealth manager would urge a client to diversify their investments. The most common example of this is maintaining a healthy balance of stocks and bonds — for instance, the frequently-dying 60/40 portfolio. But what about within the stock part of that ratio? What's the best way to diversify one's equities?

One answer is to look beyond America's borders. Some of the world's top investment firms recommend buying stock in both American and foreign companies.

"Markets outside the United States don't always rise and fall at the same time as the domestic market, so owning pieces of both international and domestic securities can level out some of the volatility in your portfolio," Vanguard says on its website. "This can spread out your portfolio's risk more than if you owned just domestic securities."

The history of the last two decades bears this out. Foreign stocks outperformed American ones every year from 2002 to 2007, according to a comparative study by BlackRock. But more recently, U.S. stocks outperformed international ones in eight of the past ten years.

So what's the right ratio of domestic to foreign stocks? Is there a 60/40 rule of thumb, or does it depend on the situation? One young investor in New York submitted this question to "Ask an Advisor." Here's what he wrote:

Dear advisors,

What would be a good allocation between domestic and international stocks? I'm a 36-year-old tech worker in New York City, and I have about $150,000 invested in index funds. Right now I have them at a 60/40 split: 60% American, 40% foreign. The purpose of these investments is to one day fund my retirement.

We just saw a decade-long period in which U.S. outperformed international, but the decade prior to that, international outperformed. In your estimate, what would be a good ratio going forward?

Thanks,

Supposing in SoHo

And here's what wealth managers wrote back:

You've already nailed it

Noah Damsky, a chartered financial analyst and principal at

Marina Wealth Advisors

in Los Angeles

This is a very straightforward answer. The MSCI ACWI IMI index can be thought of as the go-to global equity index for sophisticated institutional investors. To align with best practices, this is the benchmark our firm uses for client equity portfolios.

As of March 31 this year, the index has almost 60% U.S. exposure, so your 60 US/40 non-U.S. split is consistent with how some of the most sophisticated investors manage their geographic risk exposure. Kudos on a great job!

No way to know

Tim Melia, a certified financial planner and the founder of

Embolden Financial Planning

in Seattle, Washington

My initial response is that no one can predict the markets, and how the U.S. will perform relative to other countries is at best an educated guess.

That said, I think you have a prudent allocation between U.S. and international equities. For the sake of comparison, Vanguard's equity allocation is currently 60/40 U.S. to international equities, and Fidelity is currently at 70/30. You seem to have the same idea as these institutions, if not more conservative, which may be fine if you're concerned about being over-allocated to U.S. equities going forward.

You have a long time until retirement, and I think your allocation is prudent, assuming it aligns with your level of risk tolerance. I would encourage you to revisit your target allocation annually, and as a reference point, check whether institutions that publish their allocations have made any changes.

Buy American

John Foligno, a certified financial planner and the founder of

Grand Life Financial

in Stuart, Florida

I first want to acknowledge that you are doing a great job saving for retirement. Having accumulated $150,000 at age 36 while living in New York City is quite an accomplishment (speaking from experience, as I lived in the city in my 20s and 30s). That being said, here are some things to consider:

Diversifying globally has certainly been studied extensively by academia to create a more stable outcome than concentrating on individual stocks or a small basket of securities. Although annual stock market returns are unpredictable, specifically in the U.S., the up years have occurred much more frequently than the down years. Holding international equities would certainly be part of a diversified strategy, but 40% is high in my opinion. Consider instead holding 20% of your total international equity exposure among developed countries, emerging markets, and global real estate.

One word of caution: With index funds, there are hidden costs due to the index reconstitution effect, which has to do with adding and removing stocks from a given index, which can lead to increased trading volume and price pressure. There may be other mutual funds worth exploring that meet your risk tolerance and timing needs but have a lower expense ratio.

Given your age and life expectancy, you have quite a bit of time to allow the investments to grow. Without knowing what ratio of stocks to bonds that you hold, you should consider allocating more in stocks than bonds. In other words, you have time on your side to weather the ups and downs.

Diversify more than your stocks

John Bernstein, a financial advisor and the founder of

Bernstein Financial Advisory

in Minneapolis, Minnesota

Your question suggests that you are wisely thinking about ways to diversify your investment portfolio. However, I would strongly encourage you to think about diversification differently, and more broadly.

It is certainly a good idea to use geography to diversify a stock portfolio, but this only works to a limited extent because international and domestic stocks are part of the same asset class. Over the long term, there is a high correlation among worldwide stock returns. Unfortunately, during difficult market environments that correlation tends to go up.

The best way to fully diversify a portfolio is to use a mix of assets that respond differently to the same factors. An example of this would be a combination of stocks (foreign and domestic), government bonds, inflation-indexed bonds, and various commodities.

Once you have a portfolio with that type of diversification, then it also makes sense to include geographic diversification within the stock portion of the portfolio. In a typical portfolio that I would construct for a client, I generally allocate the stock portion of the portfolio as follows: 50% domestic, 12.5% Europe, 12.5% Pacific, 25% emerging markets (I deliberately use an emerging markets fund with a high allocation to China: 40%).

Keep in mind that those allocations are based on risk, not dollars. I use the 5-year standard deviation to calculate risk. That is a readily available statistic that is published for almost every fund.

I hope this helps. Good luck!