(PUB) Investing 2016

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The Independent Adviser for Vanguard Investors • July 2016 • 13 FOR CUSTOMER SERVICE, PLEASE CALL 800-211-7641
be in U.S. stocks, and the other 47%
should be in foreign stocks. And that’s
exactly what you’ll get if you invest in
the fund. For those who are indexing
purists, this is gospel.
Vanguard appears to be moving
towards the efficient market thesis of
matching the global markets with your
own portfolio. They currently claim that
a 40% allocation to non-U.S. stocks is
optimal, but that’s just the latest itera-
tion of the company’s advice, which
has steadily increased recommended
allocations from 10% to 20% to 30%
in the past.
Should I Stay or Should I Go?
So what’s the answer? Do the big
U.S. multinational firms owned by
domestic stock fund managers provide
enough of a foreign flavor for your
portfolio given their global reach, as
Jack Bogle would have you believe?
Alternatively, should we instead allo-
cate 50% of our portfolios to non-U.S.
companies? Or is it sufficient for a U.S.
investor to take the middle ground and
allocate just 10% or 20% of their stock
portfolio to foreign shares?
Unfortunately, there is no answer
that will satisfy every investor. For my
money, I absolutely want some expo-
sure to overseas stocks, but I don’t go
as far as Vanguard’s 40%. Using the
Model Portfolios as a guide, our foreign
stock exposure ranges from 11% to
17% when I tally up the allocations of
all the funds in those Models. So why
do I want foreign stocks?
First, it is a great big world out there.
Yes, there are over 3,600 companies in
Total Stock Market Index’s portfolio.
But even if I own every single company
in the U.S., there are over 6,000 com-
panies in Total International Stock
Index’s portfolio that I wouldn’t have
any exposure to. Companies based in
foreign lands with local, feet-on-the-
ground expertise and experience in
their own markets often have a distinct
advantage over multinationals, particu-
larly when it comes to more localized
businesses.
Yes, an oil company or a major drug
producer may be able to sell its wares
as easily overseas as it does in the U.S.,
but local cement makers, retailers and
service providers probably have a good
leg up on their foreign competitors.
Do you like Google? Google doesn’t
have anywhere near the reach in China
of Baidu, which happens to be the
third-largest holding in International
Growth’s portfolio.
Owning foreign stocks also provides
exposure to different economic and
market cycles, which helps to diversify
your portfolio. While there are times
when correlations between markets
have been high, meaning the diversi-
fication benefit was low, that hasn’t
always been the case.
Correlation is a measure of how syn-
chronized two markets are. If the U.S.
market and international markets were
in complete synchronicity, they would
have a correlation of 1.00, which implies
they move 100% in lockstep. Over the
past decade, the correlation between
U.S. and foreign markets have moved
closer to 100% as the global economy
has become more intertwined. Yet, as
you can see in the first graph above,
they’ve never been perfectly correlated,
and the recent trend has seen their syn-
chronicity lower than in years past.
I would be remiss if I didn’t discuss
two additional areas of risk that must be
weighed—currency and political risk.
Unlike owning U.S. funds or ETFs,
when you buy a fund or ETF investing
in overseas markets, you own stocks
that are valued in their local currency,
be it the Japanese yen, the euro, or
the Brazilian real. The movement of
the U.S. dollar against these curren-
cies can enhance or detract from your
returns in foreign markets. A falling
dollar makes shares in foreign curren-
cies worth more; a rising dollar makes
them worth less.
The second graph above shows the
performance of the U.S. dollar against
a blend of currencies from 26 of our
trading partners. As you can see, there
are stretches like the late 1990s and
the past five years when the dollar has
appreciated greatly against many other
currencies. But there have also been
periods when the dollar has fallen, and
this has ultimately boosted the returns
of foreign holdings.
Correctly predicting the swings of
in the currency markets is just as dif-
ficult as predicting the stock or bond
markets—it’s not a game I want to play.
Consider that famed investor George
Soros, who made $1 billion in a trade
against the British pound in 1992, was
long the pound going into the Brexit
vote, a losing bet. Oops! The pound fell
11.1% to a 30-year low against the dol-
lar in the two days following the vote to
leave the E.U.
That’s currency risk for you. Now,
what about political risk? When invest-
ing in a foreign stock fund, you are not
only making a wager on the prospects
of a set of companies, you are also
making an investment in the political
and economic stability of the countries
and markets those stocks are traded
in. Until recently, this risk was the
domain of emerging market economies.
Unsustainable levels of debt, threats
of default and currency devaluation,
rising interest rates, bank runs, failed
elections—these were supposed to >
U.S. and ForeignMarket
Correlations Have Fallen
5/745/775/805/835/865/895/925/955/985/015/045/075/105/135/16
3-year
5-year
10-year
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Cyclical Dollar
6/96 6/98 6/00 6/026/04 6/066/08 6/106/12 6/146/16
Rising line = Dollar is appreciating
(against a basket of 26 currencies)
80
90
100
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