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Globalization is under attack.
In June, Brits voted to leave the European Union, with Brexit backers vowing “to take our country back.” In July the GOP nominated a presidential candidate who vows to tear up global trade deals. And you have probably noticed that American stocks are trouncing the world’s, with the S&P 500 up 270% in this bull market, vs. 122% for an index of non-U.S. stocks. So why even bother investing abroad?
Well, that very disparity is a compelling reason to venture overseas. After a seven-year run, U.S. stocks are now more expensive, based on price/earnings ratios, than foreign shares. “Buying more U.S. stocks now is like buying the best house on a bad block,” says Russ Koesterich, head of asset allocation for the BlackRock Global Allocation Fund. “You’re likely paying too large a premium.”
On the flip side, the doom and gloom surrounding the future of the EU is creating bargains and opportunities. Research Affiliates forecasts that foreign stocks in developed markets like Europe and Japan are likely to return 6.3% a year, after inflation, over the next decade, vs. just 1.2% for the S&P 500 index of U.S. shares. Emerging-market stocks are expected to do even better: 8.1%.
Of course, as the U.K. and EU negotiate their divorce, there will be more jolts for global stocks—an index of European shares lost 13% in the first few days after Brexit, but has since rallied more than 9%.
The challenge: How do you manage the risk while taking advantage of the opportunities?
Fly into the turbulence
It seems odd to embrace the very regions that are driving market anxiety. But if you are thoroughly diversified globally, “one shock will be balanced out by other parts of the portfolio,” says Christopher Mack of Harding Loevner Global.
The investment manager Gerstein Fisher studied U.S.-only, foreign-only, and globally diversified portfolios over more than 400 rolling 10-year periods since 1970. The firm found that global portfolios (defined as 75% U.S./25% international) delivered the same 10.2% annual return as U.S.-only portfolios—but with less rockiness, notes Gregg Fisher, the firm’s founder. The global strategy never was the worst performer (or the best) in any 10-year period. The U.S. portfolio, by contrast, did the worst 56% of the time.
Calculator: What is my risk tolerance?
Keep in mind that from January 2002 through the fall of 2007, the script was flipped. Foreign stocks gained 170%, vs. just 48% for the S&P 500. “There will be a time, I am pretty darn sure, over the next 20 to 30 years where we will get the inverse of the current trend,” says Fran Kinniry, a principal in the Vanguard Investment Strategy Group.
Strike the right balance
Kinniry says allocating 40% of your equities to overseas markets is the risk/reward sweet spot. Vanguard studied foreign diversification and found that as you increase global exposure, your portfolio grows less rocky—until you hit 40%, after which volatility kicks up again.
With a 60% stock/40% bond strategy, put 36% of your overall portfolio in U.S. stocks and stash 24% abroad. Ken Moore of Global View Investment Advisors suggests keeping five to 10 points of that foreign stake in the faster-growing but riskier emerging markets.
Hedge some of your bets
When the dollar gains strength, that reduces the value of foreign returns earned by Americans. And when the buck weakens, the reverse is true. Over time, currency swings even out, but over shorter periods political and economic uncertainty can hammer foreign portfolios that do not neutralize this risk by hedging currencies.
As the euro sank nearly 20% against the dollar in the past two years, Vanguard FTSE Europe ETF , which doesn’t hedge, fell 14%. By contrast, WisdomTree Europe Hedged ETF was up nearly 6%.
Scott Opsal, director of research at the Leuthold Group, says the euro could weaken further if exiting the EU becomes a central issue in upcoming elections in France, Germany, and the Netherlands. “There could be benefit to getting rid of your currency risk as we see how things evolve across Europe,” he says. You can add some currency immunity with HEDJ or Deutsche X-Trackers MSCI Europe Hedged ETF .