Lots of people were aghast in 1996 when we began recommending that a well-diversified portfolio should have a 50/50 split between U.S. and international equity funds. We stuck by our recommendation, which remains unchanged. We certainly hope investors got the message, because the Morgan Stanley Europe Australia Far East Index known as EAFE bested the Standard & Poor's 500 Index every year from 2003 through 2007 and in the first quarter of this year. (It won’t always be that way, of course.) You will find a table of these returns at the end of this article.

Here are some of the most important things I think you should know about looking beyond our borders in search of good opportunities.

1. The potential demand for international equity funds is huge. At this time, only 13 percent of U.S. investors own international stock funds – about one of every seven. Foreign stock ownership actually is a lot higher than it looks, because many of the largest U.S. equity funds own some international companies. It’s easy to find the international component of any fund. At Morningstar.com, click on the Funds tab, enter the ticker symbol, then click on Portfolio and scroll down the resulting page. For instance you’ll find that Fidelity’s giant Contrafund (FCNTX) had 22 percent of its assets in foreign stocks early this year. Some U.S. stock funds have more than that invested internationally, and I think it can be misleading for fund companies to boast about their U.S. funds’ superior performance when a major reason for that performance may simply be their foreign holdings.

2. International investing is the greatest psychological hurdle that investors typically face when they are trying to diversify properly. We all like to stick with what’s comfortable and familiar, and the companies of our own countries fit that description well. I have read that 95 percent of the equity investments owned by Greek investors are in stocks of Greek companies. In New Zealand, the figure is 75 percent in New Zealand stocks. A quarter of a century ago, Japanese investors had 98 percent of their equity investments in Japanese companies. Investors who don’t overcome this obstacle are cheating themselves out of a world of opportunities. Before the bear market of 2000-2002, U.S. stocks accounted for roughly half of the market capitalization in the world. By the end of 2007, the U.S. share was about 31 percent.

3. Global stock funds are not the same as international ones.  Global funds, sometimes called world funds, have no geographic boundaries. Typically they have at least 40 percent of their assets in U.S. companies. If you absolutely must have only one equity fund, a global fund is better than either a U.S. fund or an international fund. But I prefer pure international funds and pure U.S. funds. Think of it like this: If you’re carefully putting together a recipe for a stew, you’ll be much more likely to succeed if you know exactly what ingredients you are using.

4. International companies may have greater long-term potential than U.S. ones.   Emerging markets economies are growing rapidly, and they have more room to grow than U.S. companies. Even many developed countries are growing faster than the United States. For every dollar of goods we exported in 2007, American consumers bought $1.44 of imported goods. In other words, our money is moving overseas. This says nothing about services, many of which are being “outsourced” to places like China and India.   

5. Combining U.S. and international funds usually reduces the overall risk of a portfolio.  You probably already know that U.S. and foreign stock markets don’t move in lockstep. And currency changes add another layer of non-correlation. In 2007, the S&P 500 Index rose 5.5 percent, the German DAX gained 22 percent, the French CAC was up 1 percent and Japan’s Nikkei lost 11 percent. The most obvious way to compare the risk of two portfolios is to determine the size of intermediate-term losses. Since 1970, the S&P 500 Index had a worst-36-months loss of more than 40 percent. But for a portfolio split equally between U.S. and international funds, the worst 36 months was a loss of only about 22 percent.   

6. International stocks can behave very differently from U.S. stocks. From 1970 through 2007, the S&P 500 Index had a compound return of 10.9 percent. The EAFE Index compounded at 10.7 percent. That makes these two indexes seem very similar, but in many individual years their performance was extremely diverse. In 1986, EAFE was up 69.4 percent vs. 18.5 for the S&P 500 Index. But in 1996, EAFE was up only 6.1 percent while the S&P 500 Index gained 33.4 percent.  

7. International stock funds are inherently more expensive to own than U.S. funds. The average large-cap international fund has an expense ratio of 1.44 percent, according to Morningstar, while the average large-cap U.S. fund’s expense ratio is 1.11 percent. This doesn’t mean you should avoid international funds. It means you shouldn’t expect their expense ratios to be comparable. The main reasons for these higher expense ratios are unavoidably higher costs for research, administration, trading and legal work when multiple countries are involved.

8. Index funds are the best way to invest internationally.  Some people believe that foreign stocks are difficult to find and require the expertise of active managers familiar with individual companies, managements, markets, etc. But international index funds have the same advantages as U.S. index funds. Index funds are much more cost-efficient and predictable in the sense that they will capture the returns of markets instead of hand-picked securities. Vanguard and Fidelity each have international index funds that focus on large-cap stocks. Dimensional Fund Advisors has a more complete lineup of funds that, though technically they are not index funds, accurately track international asset classes that include emerging markets, real estate investment trusts, large companies, small companies, value companies, small value companies and more.  

9. Investing in small companies and value companies is just as important internationally as in the United States. From 1970 through 2007, as we saw earlier, the Standard & Poor's 500 Index of large U.S. stocks grew at an annual rate of 10.9 percent. In the same years, international small-cap stocks grew at 16.1 percent. From 1975 through 2007, international value stocks appreciated at 17.5 percent, compared with 13.3 percent for the S&P 500 Index. To me, these numbers are more evidence of the value of wide diversification.   


10. The falling U.S. dollar has been good to investors in international stock funds. One reason international stocks look so good to us over the past few years is that the U.S. dollar has been falling in relative value. Since the end of 2001, the dollar is down approximately 50 percent against the Euro. That means that if European stocks were stable, to U.S. investors they would appear to have risen 50 percent. Of course this works in the opposite direction as well. When the dollar reverses course and starts to rise in value, as it most likely will sometime in the future, international securities may take a hit just because of that.


On balance, I think the case for owning international stocks is compelling. The most fundamental piece of investment advice I can give is to diversify. And worldwide geographical diversification can make a big difference.

There’s one more very important point that’s beyond the scope of this article; it’s the topic of a chapter in my book, “Live It Up without Outliving Your Money!” Here’s the crux of it: As unbelievable as it may seem, the numbers clearly indicate that to retirees who are living on withdrawals from their investments, international stocks can make the difference between a retirement portfolio that lasts a lifetime and one that runs out of money prematurely. Read Chapter 9 in my book to learn more.

Morgan Stanley Europe Australia Far East Index vs. S&P 500 Index

Unmanaged percentage returns

  Source: Morningstar, Inc.