International Investing: It’s a Mad, Mad World

In an effort to diversify my investments, I’ve become the proud part-owner of some companies I’d like to tell you about.

First, there’s BHP Billiton. Motto: Resourcing the Future! Furthermore, Billiton (as we shareholders call it for short) is “a premier global company that continues to be financially, operationally, and strategically strong.” I’m not sure what it actually does.

Next, there is Babcock. Motto: Trusted to Deliver. Babcock is the UK’s leading engineering support services company. Unlike Billiton, Babcock’s website actually mentions something the company does: It maintains police cars for the London metropolitan police.

Finally, there’s a company that needs no introduction: BP. Enough said.

It’s a mad mad mad mad world

Yes, it’s a weird and unpredictable world out there. If I lived somewhere other than the US, however, I’d probably be making fun of incomprehensible American companies. “American investors overload their portfolios with American stocks and Chinese investors overload theirs with Chinese stocks,” writes Meir Statman in his book What Investors Really Want. “We know this as ‘home bias,’ where the proportions of home-country stocks in investors’ portfolios exceed their proportions in the world portfolio.”

It’s true everywhere. US investors actually exhibit less home bias than investors in many other countries. Investors in Thailand are among the most home-biased: The average Thai investor believes that Thai stocks are safer than international stocks, despite the fact that Thailand had a military coup in 2006!

In truth, I don’t own stock in Billiton, Babcock, or BP directly. I do so via a mutual fund that tracks the MSCI All-Country World Index (ACWI). It holds about 9,300 stocks from big countries, such as the US and Canada, to small ones, like Peru.

Should you invest internationally? If so, how much of your portfolio should be located beyond your own borders?

How much international flavor would you like?

Most investment experts (but not all, as we’ll see in a minute) advise people to hold at least some international stocks. Why? The D-word, of course. Diversification is like backing up your computer. You should hold many stocks, in many sectors, in many countries, because one or more of them could crash.

Sure, they could all crash at the same time. It happened in 2008 and it will happen again. Although, if the stock markets of different countries behave differently even some of the time—which they do—then there’s a diversification benefit to be had.

My ACWI fund invests according to market capitalization. In other words, the countries with the biggest stock markets loom largest in the fund. US stocks make up 46% of the world market, and the rest of the world is 54%.

Therefore, investors should also split their stock market holdings approximately 50/50 between US and international, says Burton Malkiel, author of A Random Walk Down Wall Street. “I think people are inadequately diversified,” Malkiel told me in an interview earlier this year. “In particular, I think they are inadequately diversified internationally, and inadequately diversified in emerging markets. Where the growth is coming from in the 2000’s is not from the West, it’s not from Europe, and it’s not from the United States. It’s from the emerging markets. It’s from Brazil, it’s from China, it’s from India, and it’s from Indonesia.”

Okay, so put Malkiel down for 50%. (That’s 50% of your stocks in international, not 50% of your whole portfolio. So if you hold 60% stocks and 40% bonds, you’d have 30% US stocks and 30% international stocks.)

A contrarian view

In the other corner, we have Malkiel’s old colleague John C. Bogle, founder of Vanguard and creator of the first stock market index fund. “I don’t happen to use international because I think the market is going to be an equalizer,” Bogle told Morningstar recently. “And international and emerging markets will probably do more or less the same as the US in the next ten years.”

Bogle owns no international stocks and recommends a maximum of 20% international exposure if you feel you have to do it.

So, let’s see. We have Bogle at 0% and Malkiel at 50%. These guys are investment giants, and arguing against either of them feels like saying, “So, Mr. Einstein, this E=mc² thing…what if we tweak it a little?”

But hey, let me dust off these boxing gloves and see what I can do.

There are two problems with Bogle’s argument. First, there’s that word “probably.” Sure, over the next ten years, we have no reason to believe that, say, the British stock market will perform any differently than the US market. If the market believes Britain is going to outperform, then British stocks will be more expensive today. That’s what he means when he says “the market is going to be an equalizer.”

That’s great in theory. In practice, guess what? You can go broke waiting for markets to “equalize.” The Japanese stock market is still down 75% from its 1989 high. Seen through this lens, not buying international stocks is like not buying insurance. Probably nothing will go wrong….

Second, you know how life is about the journey, not just the destination? Same goes for investing. Even if US and international stocks end up in exactly the same place ten years from now, and even if they take different paths to get there, an investor will benefit from owning both. The portfolio as a whole will be less volatile, and you might pick up a little bonus from rebalancing along the way.

Okay, Malkiel, you’re next. If everybody knows that growth is going to come from emerging markets, that information will already be priced into emerging markets stocks. Loading up on those stocks, and international stocks in general, exposes you to additional costs and additional risk. International funds tend to have higher fees and expenses than US stock funds, by a factor of 50% or more, and they are more volatile, largely because of currency exchange rate fluctuations.

The middle ground

Phew! If you’re still with me, then you’re probably expecting me to say something like, “The real answer is probably somewhere in between.” Normally I hate it when people say that, but I think the real answer is probably somewhere in between.

In 2006, Vanguard published a paper called International Equity: Considerations and Recommendations. Here’s the take-home message: “Most of the diversification benefit has been achieved by adding an allocation to international stocks of 20%–30%.”

And they put their money where their mouth is, literally. Vanguard’s Target Retirement and LifeStrategy fund series holds 30% international stocks. If you look at offerings from other mutual fund providers, you’ll generally see the same thing. Fidelity’s Freedom Funds go with 25% international, for example.

I ended up going with 30% for my portfolio. It could be due to an exhaustive reading of the pertinent data, or maybe it’s just home bias.

Speaking of which, I could go for a burger right about now. Or, hmm, maybe Chinese food.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.