The most fundamental piece of investment advice I know can be summed up in one word: diversify. Every investor knows you shouldn’t put all your eggs in one basket. We are fervid advocates of diversification, and we believe that almost all investors should have some exposure to international stocks.

The Standard & Poor’s 500 Index, made up purely of U.S. stocks, is wildly popular these days, mostly because its performance in the past four years has beaten almost everything else in sight. But does this mean international stocks are past their prime? Does it mean U.S. investors need not look beyond their own country’s borders? No, on both counts.

Some investment gurus are finding a ready audience for the notion that the only opportunities that matter are those found in large U.S. stocks, represented by the Standard & Poor’s 500 Index. They maintain that investors can fully participate in the global economy by owning multinational companies that do much of their business overseas (prominent examples include Coca-Cola, Microsoft and McDonald’s). It’s true that international business provides valuable diversification within these companies. But the record shows (and we’ll show you) that it takes international stock funds to get the most out of an equity portfolio.

To be sure, the S&P 500 Index has had a marvelous run lately: 1995, up 37.6 percent; 1996, up 23.0 percent; 1997, up 33.4 percent; 1998, up 28.6 percent. Compounded annually in an S&P 500 Index fund, $100 invested in January 1995 would have nearly tripled, to $290 by the end of last year.

To realize how good that is, consider this: In "normal" times, a return of 12 percent is considered good, enabling an investment to double approximately every six years. If we knew that the S&P 500 Index would continue at a torrid pace, we could invest exclusively in large U.S. stocks and we’d all be rich.

But life is never that simple. Think for a moment about the investment situation in Japan exactly 10 years ago. It was obvious then to anybody who read the newspapers that Japan was on a meteoric rise. Japan’s economy, the second largest in the world, seemed to be on the brink of threatening the United States for the No. 1 position.

Now imagine you were an investor working and living in Japan 10 years ago. If you were prudent, you might have thought about buying some stocks in big U.S. companies. You would have been scoffed at. You might have been told something like this: "There’s no need to invest outside Japan; everything you could want is right here." Investment risk was seen as an outdated, stodgy concept. Nirvana had arrived.

Sound familiar? Remember, that opinion seemed just as valid as the conventional thinking in this country today, that U.S. stocks are all you need. But a funny thing happened on the way to Nirvana. The Japanese Nikkei index started falling, on its way from 39,000 yen to 14,000. Japan had a thriving mutual fund industry; but 90 percent of its assets disappeared in losses and redemptions.

Morningstar’s mutual fund database lists 33 Japanese stock funds. Only five have annualized returns going back 10 years, and only one of those was positive: 0.79 percent per year. The average annualized Japanese stock fund return from 1989 through 1998 was a loss of 3.4 percent. Over a decade, that turns $100 into $70.98. Remember, these mutual funds had invested in the stocks that Japanese investors saw a decade ago as almost a sure thing.

Japanese large company stocks, measured by Dimensional Fund Advisors, compounded at a rate of minus 6.3 percent from 1989 through 1997. That turned $100 into $55.89. Think of the shattered dreams that loss represents.

So today we give the same counsel to U.S. investors that millions of Japanese investors must wish they had heard and heeded 10 years ago: Don’t invest all your money in your own country.

The question on our minds is not whether you should have international stocks in your portfolio. The only question for us is how much. Where is the answer? Since we know the past, that’s a good place to start, and I think it’s important to go back several decades. We have reliable data going back to 1970, giving us 29 years to study. Those years witnessed a variety of market conditions, including major bear markets and major bull markets in the U.S., Europe and Japan.

In Table 1 we show year-by-year returns from 1970 through 1998 for four hypothetical all-equity portfolios, in which international stocks made up none, 30 percent, 50 percent and 100 percent of the respective totals. The returns in Table 1, Table 2 and Table 3 are based on the Dimensional Fund Advisors’ historical database.

Here’s what to look for in Table 1:

If all you care about is return, the 100 percent international portfolio should be your clear first choice. However, this mix had the worst 12-month period shown in Table 1, so it was suitable only for thick-skinned investors. And regardless of statistics, few American investors feel comfortable with an equity portfolio invested totally outside the United States. This portfolio is made up of large stocks and small stocks, growth stocks and value stocks as well as emerging markets stocks.

We think the 50 percent international portfolio is an excellent choice for most investors. By splitting your equities evenly, you essentially say: "Why choose?" In terms of compound return, this looks like a "sweet spot," two percentage points higher than that of the all-U.S. portfolio and only 1.1 percentage points below that of the all-international one. This combination has the lowest standard deviation (a measure of risk) of the portfolios in this table. And it had only one negative year in the 1990s.

Some investors simply have a hard time feeling comfortable with half their equity investments outside the country. A 30 percent international mix feels better to them. Over the past 29 years, that extra comfort cost 0.8 percentage points in compound return, compared with the 50/50 portfolio and involved higher temporary losses in most of the measures we show (worst month, worst three months, etc.).

The 100 percent U.S. portfolio had the lowest compound return in our table. It also had the worst single month, the worst quarter, the worst three years and the worst five years. This portfolio, which last year underperformed the all-international combination, is not the same as the Standard & Poor’s 500 Index; it’s made up of small stocks and big stocks, value stocks and growth stocks. (Incidentally, this portfolio outperformed the S&P 500 Index over the past 29 years, by 0.4 percentage points.) In addition, note that this all-U.S. portfolio had six losing years in the entire period, compared with four each for the 50/50 and 30/70 portfolios.

At our workshops, we show a table with more columns, one for each 10 percent increment of international stocks: 90 percent, 80 percent, 70 percent and so on. In every case, the compound return over 29 years follows the same pattern you see in Table 1. The more international stocks, the more return. But we still think a 50/50 split is very suitable for many investors.

For those who are more timid about international equities, 30 percent international stocks may be OK. But at least over the past 29 years, there was a significant performance difference between a 50 percent international equity portfolio and one with 30 percent international.

You can see that difference in a real-life situation in Table 2. But to understand Table 2, you must know that it has two fundamental differences from Table 1.

First, Table 2 shows results of a balanced portfolio, half of which remains in short-term U.S. bond funds. We believe this is a suitable allocation for retired people who want a reasonable combination of high returns (from equities) and low volatility (from bonds). The other half of each portfolio is made up of equities. We show three variations, with international stock funds representing zero, 15 percent and 25 percent of the portfolio. (These correspond to the first three versions of the all-equity portfolio in Table 1.)

Second, Table 2 is oriented toward taking annual withdrawals in retirement. We built Table 2 on the assumption that you started with $1 million at the start of 1970 and that you had an additional $80,000 for living expenses that year. We assumed that at the end of each year, you took a withdrawal 3.5 percent higher than the previous one, thus $82,800 for living expenses in 1971, $85,698 for 1972, etc.

The purpose of this table is to show how well the various investment combinations might hold up under the demands of ever-increasing withdrawals.

In the table, you’ll see that without any international stocks, such a portfolio could not survive past 1991. With only U.S. equities, the return was simply unable to support your annually increasing withdrawals. The portfolio with 15 percent international stocks held its own through 1998, though with only nominal growth. The total withdrawals over 29 years were impressive: more than $4 million. But those withdrawals pushed this portfolio, with 15 percent international stocks, about as hard as a prudent investor would want to push it.

By contrast, the portfolio with 25 percent in international stock funds tripled in value while generating the same $4 million in distributions.

This suggests that some potentially tough choices await retirees who want to take 8 percent out of a portfolio and increase that amount every year for inflation.

For example, it’s plain from Table 2 that the all-U.S. portfolio simply could not do the job. And it’s hard to imagine that the portfolio with 15 percent in international stocks could last many more years. At the end of 1999, this portfolio would be reduced by $224,543, or 21 percent of its value at the start of the year. Just to break even, this portfolio would have to appreciate 21 percent in 1999. That’s hardly realistic, especially for a portfolio invested 50 percent in bond funds. And the growing withdrawals would be an even greater burden in the future.

The portfolio with 25 percent international stocks, on the other hand, had a $3 million balance going into 1999. It could end 1999 at the break-even point if it achieved a 7.5 percent return in 1999. That’s fairly realistic, though far from certain. On the other hand, this portfolio might be badly strained if it encountered several bleak years while the distributions kept going up.

Still, the $3 million cushion at the start of 1999 would ensure another 10 years of increasing withdrawals even if the portfolio experienced no investment growth at all. And this portfolio would last another 15 years if its growth were the 5 percent that could be expected from money-market funds.

Table 2 shows clearly that if you want income that grows every year, you have to find the right balance between lower withdrawals and more aggressive investments. You could start your withdrawals with a smaller percentage, say 6 or 7 percent instead of 8 percent. Or you could make your annual increase smaller than 3.5 percent. A smaller increase might be fairly realistic for people with health care coverage, as routine living expenses are unlikely to rise dramatically in a person’s later years.

To invest more aggressively, you can load the equity part of your portfolio with a higher percentage of international stocks (though we don’t advocate going beyond 50 percent) or you can change your overall allocation to include more in stocks and less in bonds.

Those are hard choices. Before you grapple with that tradeoff, consider this: There’s an entirely different way you can think about a retirement portfolio. Future investment returns are always uncertain, and investors can’t know everything in advance. But when you design a portfolio, you can choose which factors will be variable and which ones will be fixed. In Table 2, the annual distributions are fixed; they are simply a product of your initial amount and the annual percentage increase. What’s variable is the value of the portfolio.

But think about turning this upside down, with the annual withdrawal being the variable, depending on how your portfolio performed. This won’t work for everyone, but it’s a very interesting alternative, and we show it in Table 3. Managed this way, you’d have a portfolio that can never go completely broke.

The left side of Table 3 is built on the assumption that on the last day of every year, you take out 8 percent of whatever your portfolio is worth. That 8 percent is what you live on during the coming year. The table shows those varying withdrawals over the past 29 years, along with a post-withdrawal year-end value for the portfolio. Remember, the withdrawal shown on each line is what you live on during the following year.

As you can see, this portfolio struggled through the early 1970s, then finally found its wings in the late 1970s. By the end of 1998, that portfolio had grown to nearly 2.6 times its original size while generating about $4.6 million in withdrawals.

Because this simulation held up well, we made the same set of calculations with an assumed withdrawal rate of 9 percent, reflected on the right side of that table. This turned out to be a case of more becoming less. The 9 percent variation generated only about $4.3 million in withdrawals over the 29 years and the portfolio grew to only just under $1.9 million instead of almost $2.6 million.

The 9 percent program gave you more money to spend in the first 11 years. But the pattern then reversed itself. In 1988, for example, you would have had $202,394 for living expenses from the 8 percent program but only $189,086 from the 9 percent program.

In the 1990s, your annual withdrawals averaged about $228,500 in the 8 percent program, vs. only about $198,900 in the 9 percent program. In 1999, you’d be living on $18,790 a month with the 8 percent program but only $15,566 a month in the 9 percent program. And if you were in the 9 percent program, you’d definitely understand the meaning of "More is less."

Earlier I said that this approach assures that a retirement portfolio will never go completely broke, and technically that’s correct as long as your investment losses are never 100 percent. But you could sustain a series of harsh losses that would significantly reduce both the portfolio’s size and its ability to generate income to live on. However, a string of losses would be much more detrimental if you were taking out ever-increasing withdrawals, as we showed in Table 2.

If nothing else, these studies illustrate that you have to consider quite a few things in order to build a successful retirement portfolio. You have to balance your need for certainty of income against the possibility of going broke. (Do you pick from Table 2 or from Table 3?) You have to weigh your need for more income in the early years of retirement (the 9 percent program in Table 3) against the desire for eventually higher income (the 8 percent program).

And of course you have to balance your stocks between U.S. and international. U.S. stocks are more familiar. But at least over the past 29 years, international stocks have produced significantly higher returns.

I think there’s another very important lesson hidden in Table 2: It’s the enormous impact over time that comes from very small differences in compound rates of return. Look again at the final balance of each portfolio in Table 2. One was zero, one was $1.07 million and the third grew to $3.04 million.

Those huge differences resulted from changing the investments in only one quarter of the portfolio. Each portfolio contained 50 percent U.S. bonds and at least 25 percent U.S. stocks. The final 25 percent was invested either in U.S. stocks, international stocks or a combination of both.

Even more striking, the first 90 percent of the two portfolios that survived were identical: 50 percent bonds, at least 25 percent U.S. stocks and at least 15 percent international stocks. The only difference was that last 10 percent: In one case it was in U.S. stocks, in the other international stocks.

In other words, the choice you made for investing 10 percent of your portfolio made the difference between $1 million and $3 million. The U.S. stocks earned a compound rate of return (CRR) of 13.9 percent. International stocks earned a CRR of 17.0 percent. Applied to only 10 percent of the portfolio, that difference turned out to be worth about $2 million.

Even more startling, the compound rates of return on the three entire portfolios were very close, as you can see in the table. The difference between going broke in 1992 (11.4 percent CRR) and having $3 million left at the end of 1998 (12.3 percent CRR) resulted from less than one full percentage point of compound return.

To borrow a song title from a minor hit of the 1950s, little things can mean a lot.

 

 

Discover how professional money management can help you.  Get a Free Consultation from a Merriman financial advisor.