International Equities: How Much Should You Invest?

The percentage of investments allocated to international equities is a highly debated topic, with investors advocating for anywhere between 0% and 40% of one's portfolio. Vanguard, a well-known investment firm, recommends that investors allocate at least 20% of their overall portfolio to international stocks and bonds, with an option to increase this allocation to 40% of their stock portfolio to gain the full diversification benefits. However, Vanguard's founder, John Bogle, was famously sceptical of international diversification, believing that US-based companies already provide sufficient global diversification due to their global footprints and operations.

Proponents of international equities highlight the benefits of diversification, tapping into faster-growing or underpriced economies, and hedging against the decline of the US dollar. On the other hand, critics argue that international markets can be more volatile and prone to political instability, currency fluctuations, and trade disputes. Ultimately, the allocation to international equities depends on an investor's risk tolerance, time horizon, and investment strategy.

How much international equity should you own?

The percentage of investments allocated to international equities is a highly debated topic, with investors advocating for anywhere between 0% and 40% of one's portfolio. The answer depends on several factors, including risk tolerance, investment goals, and market conditions.

Diversification Benefits

Proponents of international equities highlight the benefits of diversification. Investing in international equities provides exposure to different markets, economies, and sectors that do not always move in sync with the US market. It offers a hedge against the decline of the US dollar and provides access to faster-growing or underpriced economies, particularly in emerging markets.

Home Country Bias

On the other hand, some investors prefer a home country bias, arguing that US-based companies often have significant international operations, sales, and suppliers, providing indirect international exposure. Additionally, US investors may prefer to bet on their own country's economy and consume primarily in USD.

Market Performance

The performance of international equities compared to US equities has varied over time. In the past decade, US equities have outperformed international equities, but there are indications that this trend may reverse in the coming years. International equities are currently undervalued compared to US stocks and could offer higher returns if their economies grow faster or benefit from rising commodity prices.

Allocation Recommendations

Vanguard, a well-known investment firm, recommends that investors allocate at least 20% of their overall portfolio to international stocks and bonds, with an option to increase it to about 40% of their stock allocation for full diversification benefits. T. Rowe Price, another investment firm, suggests a 70% US and 30% international equity allocation for long-term portfolio performance and consistency.

Ultimately, the decision on how much international equity to own depends on an investor's individual circumstances, risk tolerance, and investment goals. It is essential to consider the benefits of diversification while also recognizing that past performance does not guarantee future results.

Pros and cons of international investing

Investing in international equities can be a valuable addition to a well-diversified portfolio. Here are some pros and cons to consider:

Pros of International Investing:

• Diversification: Investing in international assets helps reduce the overall risk of your portfolio by spreading your investments across different geographic regions. If the domestic market experiences a downturn, international markets may continue to perform well and provide a buffer against losses.
• Growth Opportunities: International investing allows investors to take advantage of growth opportunities in foreign markets. It provides exposure to different economic and market forces in other countries, which can lead to higher returns.
• Offset Domestic Risks: By investing internationally, you can potentially offset losses in your domestic investments. International markets may perform differently or be less affected by domestic economic and political events, such as recessions, policy changes, or natural disasters.

Cons of International Investing:

• Higher Costs: International investing often involves higher transaction costs, currency exchange fees, and the need to work with brokers or investment advisors, resulting in additional expenses.
• Currency Risk: The value of international investments can be significantly impacted by fluctuations in currency exchange rates. A weakening of the foreign currency relative to your home currency can reduce the returns on your investment.
• Complexity and Regulatory Differences: Navigating international investments can be complex due to different economic, political, and regulatory environments. Understanding these differences and staying compliant with foreign regulations can be challenging.
• Liquidity Risk: International investments may carry higher liquidity risks, and it may be more difficult to convert foreign investments back into your home currency or withdraw your money in certain situations.
• Country/Regional Risk: Investing in international equities exposes you to country-specific or regional risks, such as political instability, financial troubles, or natural disasters, which can adversely affect the value of your investments.

How to allocate international equity

There are many different opinions on how to allocate international equity, with percentages ranging from 0% to 40% of your overall portfolio.

The Case for International Equities

Firstly, it is important to note the benefits of investing in international equities. One of the key tenets of investing is that broad diversification can help reduce volatility. Investing in international equities can help investors mitigate the idiosyncratic risk of investing solely in domestic stocks. By investing in international equities, investors gain exposure to a range of economic and market forces in other countries that tend to produce returns different from those of their home market. This geographic diversification can also help investors achieve higher relative returns.

Percentage Allocation

• Vanguard recommends that at least 20% of your overall portfolio should be invested in international stocks and bonds, with an ideal allocation of about 40% of your stock portfolio in international stocks.
• Some investors allocate to international equities based on market share, taking into account the size (market capitalisation) of all the markets and proportionally allocating their investments. As of April 2024, the MSCI All Country World ex Australia Index (MSCI ACWI ex Aus) had a 10% allocation to emerging markets, which would imply a 10% allocation of the total international equity portfolio to emerging markets.
• Another approach is to allocate based on GDP weight, as emerging market economies are growing at a faster pace than developed markets, offering potentially higher equity returns. As of 2024, the percentage of global GDP generated by countries with the MSCI Emerging Markets Index was close to 47%, which would suggest an allocation of 47% to emerging market equities.
• A combination of the market share and GDP weight approaches suggests an allocation of around 28% to emerging markets.
• Using the Efficient Frontier from Modern Portfolio Theory, which suggests the most efficient investment portfolios for a set level of risk, an optimal allocation to emerging markets could be as high as 37.68% for investors with a high level of risk tolerance.
• Some investors allocate 20-25% of their equity portfolio to international equities.
• T. Rowe Price suggests an equity allocation of 70% US and 30% international.
• John Templeton, a stock picker who built a spectacular record via a cosmopolitan perspective, had an allocation of around 40% to international equities.

Other Considerations

• It is important to consider your risk tolerance when allocating to emerging markets, as they are considered riskier than developed markets.
• Some investors may want to avoid international equities altogether, as per John Bogle's famous recommendation to only invest in US stocks. Bogle argued that the S&P 500 already provides ample global diversification due to the global footprints of the largest US corporations.
• Currency hedging can be used to reduce the volatility of a foreign stock portfolio by insulating investors from the impact of a rising dollar. However, this can increase fees and may not provide better returns over the long term.
• It is generally recommended to hold foreign stocks in a taxable account, as this allows investors to reclaim foreign taxes taken out of dividends as a credit against their US tax bill.

International equity allocation strategies

There are a variety of strategies and viewpoints when it comes to determining the ideal allocation of international equities within an investment portfolio. Here are some key considerations and approaches:

• Geographic Diversification: A key principle in investing is that broad diversification can help reduce volatility. By investing solely in domestic stocks, investors are exposed to idiosyncratic risk, even if their portfolios are diversified within their home market. Including international equities provides exposure to a wider range of economic and market forces, which can help mitigate portfolio volatility. Vanguard's Ian Kresnak, a CFA and investment strategy analyst, recommends a geographic diversification approach, suggesting a mix of around 60% domestic stocks and 40% international stocks.
• Risk Tolerance and Return Expectations: The allocation to international equities should also consider an investor's risk tolerance and return expectations. Emerging markets, for instance, are generally considered riskier than developed markets but may offer higher potential returns. Risk-averse investors may prefer a smaller allocation to international equities, while those with a higher risk tolerance may opt for a larger allocation.
• Market Capitalisation and GDP Weighting: Some investors allocate their international equity exposure based on the size (market capitalisation) of different markets or the contribution of those markets to global GDP. As of April 2024, the MSCI All Country World ex Australia Index had a 10% allocation to emerging markets, suggesting a 10% allocation of the total international equity portfolio to emerging markets. However, this allocation can change over time due to market performance and economic growth.
• Efficient Frontier and Modern Portfolio Theory (MPT): The Efficient Frontier, derived from MPT, suggests the most efficient investment portfolios for a given level of risk. Using historical data, investors can determine the optimal allocation between developed and emerging markets based on their risk tolerance. This approach may result in a higher allocation to emerging markets for investors seeking high growth.
• Home Country Bias: Some investors prefer a home country bias, overweighting their portfolio towards domestic equities. This may be due to tax considerations, familiarity with the local market, or a belief in the strength of the domestic economy. However, it's important to note that this approach can introduce concentration risk and reduce the benefits of diversification.
• Global Market Weighting: Some investors opt for a passive approach, mirroring global market weightings. This typically results in an allocation between 60/40 and 55/45 US/international equities. This strategy ensures a neutral portfolio positioning without making active bets on specific regions or countries.
• Cost and Tax Considerations: Costs and taxes can also influence international equity allocation decisions. For example, foreign investments in taxable accounts may offer tax benefits, such as the ability to reclaim foreign taxes as a credit against domestic tax liabilities. Additionally, expenses and fees associated with international investments, such as foreign transaction fees or higher expense ratios, should be factored into allocation decisions.
• Sector Exposure and Economic Factors: Allocations can also be influenced by sector exposure and economic factors. For instance, international equities may provide exposure to sectors that are underweighted in the domestic market, such as financials and industrials. Additionally, economic trends, such as rising commodity prices or digital revolution, can favour specific regions or countries.
• Expert Recommendations: Vanguard, a well-known investment firm, recommends a minimum of 20% allocation to international stocks and bonds within an overall portfolio. However, they suggest investing about 40% of the stock allocation in international stocks to gain the full diversification benefits. T. Rowe Price, another investment firm, suggests a 70% US and 30% international equity allocation for long-term portfolio performance and consistency.

In conclusion, there is no one-size-fits-all approach to international equity allocation strategies. Investors should carefully consider their investment goals, risk tolerance, tax implications, and market conditions before determining their allocation. Diversification, risk management, and a long-term perspective are key tenets to keep in mind when constructing an international equity allocation strategy.

The importance of diversification

Diversification is a key tenet of investing. By spreading your investments across various asset classes, you can reduce the volatility of your portfolio and manage risk more effectively. This means allocating your capital across stocks, bonds, mutual funds, exchange-traded funds (ETFs), and specific industries and market sectors. The aim is to mitigate risk and increase the potential for returns.

For example, if you were to invest 100% of your portfolio in stocks, a 10% drop in the stock market (a common occurrence) would wipe out an entire year's worth of growth. However, if you had a diversified portfolio with bonds and real estate investments, the impact of the market drop would be mitigated as it is less likely that all your investments will lose value simultaneously.

It's important to note that diversification does not guarantee against loss. The "right" amount of diversification depends on your specific goals, risk tolerance, timeline, and personal preferences. Quality over quantity is critical—you need to find a balance that aligns with your ability to monitor and manage your investments effectively.

A well-diversified portfolio can also help preserve capital for older investors in or near retirement. Additionally, diversification can be particularly beneficial for aggressive investors, as it can provide greater protection if something goes wrong with a high-risk investment.

International equities can play an important role in diversification. They can provide exposure to an array of economic and market forces in other countries, which tend to produce returns different from those of the domestic market. This can help reduce portfolio volatility and enhance returns over the long term.

Some investors allocate a portion of their equity portfolio to international stocks, typically ranging from 20-40%. Others prefer to allocate based on the global market cap, which currently stands at around 40% international equities.

In conclusion, diversification is a crucial aspect of investing that can help you manage risk and maximise returns. By allocating your capital across various asset classes and geographic regions, you can reduce volatility and enhance the long-term performance of your portfolio. The specific allocation depends on your individual goals, risk tolerance, and investment horizon.

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