How foreign stocks fit into your portfolio

International stocks should be a part of any diversified portfolio, but they're not a shelter against domestic rough spots.

Question: Given the way the U.S. stock market has been behaving, what are your thoughts of buying foreign stocks versus domestic shares? —Henry, San Antonio, Texas

Answer: If you’re thinking of moving into foreign stocks because they’ll offer shelter at a time when U.S. shares are being hammered, you may end up being disappointed. Academic research has shown that when the U.S. stock market gets slammed, foreign bourses also find themselves reeling.

That’s certainly been true lately. Foreign shares as measured by the broad MSCI EAFE index, are down about 19% from the beginning of the year compared with a 12% decline for the Standard & Poor’s 500 index. And some foreign markets have taken an old-fashioned whupping: witness the drop of just over 50% in the value of Chinese shares in the Shanghai Composite Index.

Similarly, if you’re being drawn to foreign shares because they racked up big gains before their recent setback, you may need to re-calibrate your expectations a bit on that front too. Some of those attractive returns were the result of a slide in the value of the U.S. dollar. American investors who own foreign stocks benefit when the greenback drops and foreign currencies rise since profits in shares denominated in foreign currencies buy more U.S. dollars. With European economies weakening and commodity markets struggling, however, the dollar has been rallying lately. Which means that currency tailwind effect could abate, or even turn into a headwind.

Why invest overseas?

So if foreign stocks may not provide the security of higher ground during a deluge and the dollar’s recent booster effect may be waning, why do I still think it’s a good idea for U.S. investors to have a portion of their portfolios invested abroad?

The answer is that, propelled by growth in their economies, foreign shares can generate strong long-term returns aside from any currency effect. And despite foreign stocks’ tendency also to retreat when U.S. shares drop sharply, foreign equities still offer valuable diversification benefits during those times when the U.S. stock market isn’t operating in bear mode, which, after all, is most of the time.

Analysts measure the extent to which domestic and foreign stocks zig and zag relative to one another by looking at a statistic known as the correlation coefficient. The propensity of domestic and foreign shares to move together can vary for a number of reasons, including trade policies and a general move toward globalization. But over long periods of time correlations are generally loose enough so that adding foreign stocks to an all-USA portfolio can enhance the tradeoff between risk and return (that is, boost your portfolio’s returns without increasing risk or deliver the same return while lowering risk).

Build a portfolio

There are several ways to reap this benefit. One is to create a portfolio diversified by industry sectors (consumer staples, financials, technology, etc.), and then buy stocks of the best companies in those industries whichever country they happen to be located in. While this approach can be effective, it requires quite a bit of time, effort and skill to identify top companies around the globe and then monitor such a portfolio.

Another strategy is to add international exposure country by country, depending on which nations you feel offer the best opportunities for diversification and return. There are certainly enough single-country and regional mutual funds and ETFs around to allow you to take this route if you wish. But pulling it off successfully assumes you know which countries to buy, how much of your portfolio you should devote to each and how to keep tabs on and adjust your far-flung holdings.

And then there’s a much simpler approach that I believe is appropriate for most people - just devote a portion of your stock portfolio to a broadly diversified international stock fund. You can find suitable candidates by checking out the actively managed, index and ETF sections of our Money 70 list of recommended funds.

Reasonable people can and do differ as to how much exposure to international markets individual investors ought to maintain. But, I think 20% to 30% is a sensible range.

Stay the course

Whatever percentage you decide is right for you, the important thing is that you largely stick to it. In other words, avoid the temptation to plow more money into foreign stocks when they’re outpacing U.S. shares and to scale back your international holdings when domestic stocks are surging.

There are no guarantees, of course, but over time the approach I’ve outlined should enhance your portfolio’s overall returns and reduce risk. Not eliminate risk, mind you. You’ll still have to deal with periods when both U.S. and foreign shares slump. But that’s what bonds are for.