In our ongoing series looking at asset allocation issues, we’ve already covered some essentials, namely, how to analyze your ability, willingness and need to take risk — and what do when one or more of those factors conflict. Figuring out where you fit along the risk spectrum will help you figure how much of your portfolio to put into stocks.
Now, we’ll start looking at some next steps. Once you’ve determined the appropriate percentage of stocks to hold, you’ll have to to determine the appropriate mix between domestic and international stocks. (You’ll also have to tackle how much to allocate to value vs. growth stocks, small-cap vs. large-cap and how much to put into real estate — all topics we’ll cover in follow-up articles.)
Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. During long periods, U.S. stocks have performed relatively poorly compared to international stocks. The reverse has also been true.
But over the long term, returns have been similar. Thus, the gains from international diversification come from the relatively low correlation among international securities. This is especially important for those employed in the U.S. because it’s likely their labor capital is highly correlated with domestic risks.