At a high level, the reason that you will want to add international investments to your equity portfolio is due to the fact that the price movements are not highly correlated with the returns of US equities. Because of this low correlation, it provides decreased risk and increased returns through the power of diversification.
Optimal Split –
A study published in the Journal of Investing in 1998 took an in-depth look at the performance and risk associated with different portfolios with varying asset allocation levels of international/domestic US equities.
The results of the study showed that the split that showed the optimal performance was an equity portfolio with 40% international and 60% US domestic. This allocation provided the highest returns with the lowest risk/price volatility. In other words, it had the highest Sharpe Ratio.
Finding The Split That Suits You Best –
While the 40% international allocation described above is the “optimal” split, as defined by academic research, it doesn’t necessarily mean that you should allocate 40% of your equity holdings to international investments.
Why is this you might be asking? The answer lies in the fact that an investment strategy is only as good as an individual’s ability to stick to it, even in the worst of times. The worst thing that could happen is that you determine several years from now that the 40% international equity allocation you decided upon is too much risk for you, and it causes you to sell off all of your holdings.
Therefore, in my opinion, the best approach is to use the 40% optimal split as the highest international allocation that anyone should employ in their investment strategy.
In other words, only the heartiest of souls that are very young (in their 20’s) should allocate 40% of their equity holdings to international investments.
For the rest of us, Burton Malkiel describes the following recommended allocations (based on age) in his famous book, A Random Walk Down Wall Street. As you can see in the table below, even for people in their 20’s, Malkiel recommends that they only have 30% of their equity funds allocated to international instruments. I feel this level is very appropriate.
So, take a look at the table below to define at a high level of how your equity portfolio will be constructed.
In Part 5 of this series, I describe how you can determine the specific mutual funds that should make up the US domestic and international portions of your equity portfolio.
Keep on learning!
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