We are often asked why we recommend investors keep half their equities in international funds. But we never hear that question from readers who took this article to heart when it was last updated in 2003.

The U.S. stock market has essentially been in the pits for the past three years, and international markets haven’t been a lot better. But there’s still an enormous benefit to long-term investors who balance U.S. equity investments with international ones.

Whenever we can, we persuade our clients to split their equity funds equally between U.S. and international. Last year, those clients were very glad they did. In fact, international funds saved a lot of investors’ bacon last year. The reason wasn’t that foreign stocks did particularly well. It was that the value of the U.S. dollar fell in relation to many foreign currencies.

How this happens isn’t immediately obvious, but it’s simple. If a stock in Europe is priced at 50 Euros and the Euro is worth $1.08, one share of that stock is worth $54. If the value of the dollar drops so that the Euro is worth $1.11, then a stock priced at 50 Euros is worth $55.50. The price of the stock didn’t change, but it became more valuable to U.S. investors when the dollar dropped in value.

I’m not advocating international funds as a way to speculate on currencies. I’m advocating them as a way to reduce risk. And for retirees, reducing risk sometimes improves returns to a huge degree.

Many retirees are risk-averse, and they regard international funds as riskier than sticking to investments in U.S.-based companies they know and trust. This is normal. British investors are most comfortable investing in British companies, and the same is true in many other countries.

This tendency – to trust what we can see and what we think we know – also explains why so many people load up their 401(k) accounts with stock in the company for which they work. (Yet it’s very risky to count on only one company for your income, your benefits and your retirement, too.)

Investors’ tendency to seek what’s familiar and comfortable can cost them a lot of money.

Whenever we can, we advocate wide diversification. We recommend roughly equal weighting in large-cap stocks and small-cap ones, in growth stocks and value stocks, and of course in international stocks as well as U.S. ones.

One of the standard retirement scenarios we use when we’re working with clients assumes that an investor retires with $1 million and takes out $60,000 the first year for living expenses, increasing the annual withdrawal by 3.5 percent every year to cover inflation.

The most important thing we look at in this simulation is not the annualized return. It’s the value of the portfolio from year to year after the effect of the scheduled withdrawals, which go up relentlessly every year. The thorough equity diversification we described above plays a key role in giving a portfolio the strength it needs to withstand those ever-increasing withdrawals.

To show that, we applied the scenario of an investor retiring with $1 million, taking out $60,000 the first year and 3.5 percent more every year after that, to a few portfolio variations, starting with 1970 and continuing through 2002.

When the portfolio was invested exclusively in the Standard & Poor's 500 Index, we found that by the end of last year it would have been worth $464,793. Last year’s distribution would have been $180,402. With distributions continuing to grow, that theoretical portfolio was clearly doomed. It had held up for 33 years, but it couldn’t last longer than a couple more years.

But what, we asked the computer, if that portfolio had been invested in an all-U.S. mix of our recommended asset classes: large-cap stocks, large-cap value stocks, small-cap stocks and small-cap value stocks?

In this case, the portfolio would have been worth $10,347,128 at the end of last year. That’s right, that’s more than 20 times as much money as an investor would have had in just the S&P 500 Index. (There was no change in the 2002 distribution, since in this scenario that is governed by a formula rather than portfolio performance.)

Then we asked for the results of the same scenario when the portfolio was invested in a global mix of diversified funds. The U.S. half of this portfolio was identical to the one in the previous example. The international side was invested equally in large-cap stocks, large-cap value stocks, small-cap stocks, small-cap value stocks and stocks in emerging markets.

At the end of 2002 that portfolio would have been worth $33,199,156 – more than 70 times the amount from a portfolio that was limited to the S&P 500 Index. The distribution last year would have been the same $180,402. But with a portfolio this big, a retiree could be excused for dipping in for a little bit extra from time to time!

We know that most retirees are uncomfortable with an all-equity portfolio. In addition, we understand that value stocks, small-cap stocks and international stocks are regarded as risky. So we ran another simulation, in which half the portfolio was the same as the one I just described and the other half was in short-term bond funds.

That huge stake in conservative fixed-income funds would have reduced risk substantially while it let the portfolio grow to $12,098,955 by the end of last year.

The table below summarizes this: Let’s look at those numbers, one by one, to see the story they are telling us.

First, the number $464,793 tells us that relying exclusively on the S&P 500 Index won’t maintain retirement withdrawals that can be counted on. With the returns in the years we studied, this strategy would have left a retiree broke in about 35 years, with no more income and nothing to leave to his or her heirs.

Second, the number $10.3 million tells us that, at least over the past 33 years, it was relatively simple to avoid running out of income and money: Just add proper asset class diversification. Even if that portfolio had no further growth or income at all, it could continue paying the ever-increasing distributions for an additional 30 years – for a total of 63 years after the investor retired. That’s a pretty healthy cushion!

Third, the figure $33.2 million tells us that over the years, a retiree following this systematic withdrawal plan could more than triple the eventual portfolio value by adopting global diversification rather than sticking to U.S. companies.

Finally, the number $12.1 million tells us that global diversification makes it possible to achieve equity-style returns while keeping half the portfolio in short-term bond funds. That greatly reduces the risk of the overall portfolio, something that most retirees will appreciate.

There you have, in just four numbers, the case for international equity investments. Over any short period of time, international stocks might or might not add value to a portfolio. But over long periods of time, they have unquestionably done so.

Here’s one other example, going back farther than 1970 and using a single asset class to offset the Standard & Poor's 500 Index: large-company stocks from Great Britain. We chose United Kingdom stocks because data for them is readily available going back to 1956. We measured it over 30 years, a span in which most retirement portfolios need to be able to hold up.

We found that a portfolio starting with $1 million in 1956, all invested in the Standard & Poor's 500 Index and with the same withdrawal schedule as outlined above, would have dried up too soon to meet many retirees’ needs. At the end of 1985, after 30 years, the portfolio would have had only $112,857 in it, not enough to meet the following year’s planned withdrawal of $168,408.

But a portfolio equally divided between the S&P 500 Index and a similar index of British stocks would have finished 1985 with a value of $4.75 million.

Another interesting thing happens when U.S. and international equity assets are combined: They reduce risk. Below, you will see four simple graphs, Figures 1 through 4, each showing return and risk results for two asset mixes.

These graphs can teach a valuable lesson to anyone willing to spend a few minutes figuring out what they show. Figure 1 is a good example, showing the effects of various combinations of investments in the Standard & Poor's 500 Index and the Morgan Stanley Europe Australia Far East Index known as EAFE.

The dot at the upper end of the curved line represents the results of the S&P 500 Index alone. The vertical axis of the chart represents annualized return, in this case from 1970 through 2002. The horizontal axis represents risk, measured by standard deviation. An ideal investment would be represented by a dot high on the chart (for high return) and far to the left (for low risk). The closer to that corner of a chart you can get, the more favorable the combination.

In Figure 1, the end of the line marked EAFE Index indicates a return of slightly over 10 percent and a risk with a standard deviation of 18.9 percent. The other end of the line indicates that the S&P 500 Index had a return of 10.8 percent and a standard deviation of 17.7 percent.

As the line moves left away from the upper end, each dot represents an additional 10 percent allocation to EAFE. As you can see, adding even a small amount of international funds can reduce risk considerably and raise the return slightly. The combination that’s closest to the upper left corner represents a mix of about 60 percent S&P 500 Index and about 40 percent EAFE. That’s the “sweet spot” of this particular curve.

Once you understand how to look at such a chart, you can see the relationships in other asset combinations.

Figure 2 represents the same analysis for our recommended mixes of diversified U.S. equities and diversified international equities. In this case the international securities had higher returns than the domestic ones.

If you trace from the bottom of the curve, you’ll see that adding even 30 percent in international equities makes a big contribution to return and to risk reduction. The “sweet spot” combination in this graph that is closest to the upper left corner is 60 percent international and 40 percent U.S. equities. A 50/50 split, which we recommend, provides almost precisely the lowest risk, according to the chart. That combination had an annual return of 14.8 percent, up from 13.2 percent in the all-U.S. portfolio.

Figures 3 and 4 show “balanced” combinations in which half of each portfolio is invested in Treasury bills. Figure 3 shows results for EAFE and the S&P 500 Index, while Figure 4 shows results for our recommended diversification mix, both domestic and international. Note that while the curves in these charts are very similar, the returns in Figure 4 are considerably higher than those in Figure 3, representing the positive effect of asset diversification.

Despite this historical evidence, many investors, including some professional ones, are very hesitant to have much international exposure. Recently I received an email from an advisor looking for data of exactly the type we’re presenting in this article.

“I am having a difficult time convincing my investment committee to increase our international exposure,” the advisor wrote. “On average, we probably have about 15% of the equity part of our models committed to international.”

As these graphs show, that is not the way to get the best combination of risk and return.

Some advisors say owning big multi-national companies provides all the international exposure that U.S. investors need. It’s true that many companies like that will benefit when overseas business climates are booming and will suffer when business is poor overseas.

But anybody who owns an S&P 500 Index fund has plenty of exposure to such companies. Owning more of them, in the name of international investing, is just piling on more large-cap (in many cases giant-cap) U.S. growth stocks. These are by and large high-quality companies with correspondingly low returns – a reflection of the age-old tradeoff that investors get paid for taking calculated risks and that those who stick with what’s safe and comfortable won’t collect premium returns.

The most popular investments are generally large-cap blend funds like the S&P 500 Index funds and actively managed funds like Fidelity Magellan (FMAGX) and many funds labeled “growth and income.” These funds tend to invest in the same type of stocks that are comfortable, convenient and regarded as safe. From the perspective of a fund salesperson, these funds and the stocks they own are relatively easy to sell, especially in bull markets.

We have some of those funds in our equity portfolios, of course. But we’re looking for ways to do better. To the large-cap blend funds, we add small-cap funds and value funds in order to increase return. Over many years, small-cap stocks and value stocks have produced higher returns than the S&P 500 Index.

We add international stocks not necessarily for extra return. Look at Figures 1 and 3 and you’ll see that international stocks, at least as measured by the large-cap companies in the EAFE, have underperformed the S&P 500 Index over long periods of time.

We add international stocks because they reduce risk when they’re combined with U.S. stocks. You’ll see that unmistakably in Figures 1 through 4.

In some time periods, U.S. investments perform better than international ones. But there are other times when international equities are the clear winner.

We found reliable data going back to 1956 for the FTSE, an index of large-company stocks in the United Kingdom. As a proxy for international stocks, we used that data through 1969. For periods from 1970 forward, we used returns for EAFE. For the entire period, we used Standard & Poor's 500 Index to represent large-company U.S. stocks.

With that data, we looked at all five-year periods and all 10-year periods.

Starting in 1956, there are 38 10-year periods (most of them overlapping, of course) through 2002. In 23 of those periods, the return was higher from international stocks than from the S&P 500 Index.

There were significant unbroken stretches of time in which international stocks outperformed, including, for instance, every 10-year period ending from 1985 through 1994. And there were significant stretches when the S&P 500 Index outperformed, for instance every 10-year period ending from 1995 through 2002.

When we studied the 43 five-year periods ending in 1960 and later, we found that large-cap international stocks excelled in 22 and the S&P 500 Index excelled in 21. Again, there were significant stretches when one asset class or the other had a string of successes. This undoubtedly led many investors to conclude that one or the other of them was no longer worth investing in.

The average return for all the five-year periods was 11.7 percent for international stocks and 11.7 percent for the S&P 500 Index. For all 10-year periods, the annualized returns averaged 11.5 percent for international stocks and 11.4 percent for the S&P 500 Index.

If you noticed that those two annualized returns are virtually the same, you are right on target. So you might ask: What’s the big deal? The answer: survival.

What retirees need most is a lower-risk way to achieve the returns that will let them reach their goals. International stock funds provide that.

As it turns out, retirees need international equity funds even more than pre-retirement investors.

 

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