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As you’ve probably noticed here lately, I have been doing a lot of analyses of my own personal finances and investing strategy. In the course of these analyses, I have been re-reviewing some of the books that helped me formulate my passive investing strategy several years ago.
One fascinating topic of analysis that I wanted to take a look at in today’s post is an answer to the following question – “What is the best international equity allocation level one should use in their portfolio?” Well – let’s investigate this further!
In my opinion, adding the international equity asset class is the 3rd most important decision one makes in putting together their investment portfolio (right after #1 – choosing passive investing over the loser’s game of active management and #2 – deciding your overall equity/fixed income asset allocation based on your personal risk tolerance and investing horizon).
So, why is the addition of international equity such an important step to constructing a portfolio?
Essentially, it all comes down to correlation and diversification. Since international equity, US domestic equity, and fixed income portfolio components all move up and down in different ways/magnitudes, you get a diversification benefit by including them in your portfolio.
In simpler terms, this means that by adding international stocks, you get a higher overall portfolio return at a lower volatility/risk level (sometimes called efficient frontier). This is perhaps the most exciting and interesting thing to me regarding portfolio construction!
Note: In everything that I read, the over-riding theme was that you should only pick an international equity allocation that you can live with. If you choose the most efficient allocation in the world but cannot stick with it in good times and bad, it defeats the entire purpose.
Conclusion from the literature – From the books written by the three authors above (some of the best on asset allocation I have found to date), it seems that the optimal allocation for international equities is between 30-40% of total equity holdings, with 40% likely being the “most efficient” single point.
Having taken a look at the advice given in the literature about the best levels in which to hold international equities in one’s asset allocation, I then wanted to do some of my own analysis and number crunching to see how things looked for myself over a time scale I could control.
To do this, I went to Yahoo Finance (the site where I always get my historical pricing data) and downloaded the historical price information for the 4 Vanguard mutual funds shown below:
Whenever I do these types of back-test analyses, I generally like to pick the longest time period I can get access to. In this case, the historical pricing data only went by 16.75 years, to 1996. Therefore, the time period I chose for the analysis was 1996-2013 (present).
First, I wanted to analyze the pure fluctuations/growth of the individual mutual funds (1-component portfolios) over the time period. To do this, I simulated the growth of a $10,000 initial investment in 1996 in each of these funds.
The graph below shows the overall results, where the blue line = Vanguard Total US Stock Market Index Fund, the red line = Vanguard Short-Term Bond Index Fund, the green line = Vanguard Total International Index Fund, and the light blue line = Vanguard Emerging Markets Index Fund.
To add some definite numbers to the performance of the 1-component portfolios shown in the chart above, I generated the table below, displaying year-to-year, month-to-month, and total return data for the 1996-2013 holding period.
The chart and table above shows us some interesting findings.
While examining the “personality” of an asset class in the isolation of a 1-component portfolio is interesting, an even more important thing to look at is how the fund will perform when mixed in as part of an investor’s real life asset allocation.
To investigate this activity, I simulated the growth of the same $10,000 initial investment from 1996-2013 (present) using a 70% equity / 30% fixed income overall asset allocation portfolio. The 30% fixed income portion consisted solely of the Vanguard Short-Term Bond Index Fund mentioned previously, while the 70% equity allocation was split up employing varying levels of international equity (Vanguard Total International Stock Index Fund) holdings, from 0-60% of total equity position, along with using the Vanguard Total US Stock Market Index Fund for the domestic equity allocation..
The return data for the growth of the $10,000 initial investment from 1996-2013 utilizing various levels of international equity can be seen in the table below:
However, even though the average annual return decreases across the board as we increase our international equity exposure, we are getting the diversification benefit because the volatility/standard deviation is definitely decreasing as well.
Lastly, if we look at the far right column of the table above (the inverse of the return/risk curve slope), we see that the largest numbers occur between 10-30% international equity levels. What this means in plain English is that we get the largest decrease in volatility per unit decrease in return between 0-30% international equity. This is definitely the area where we would want to have been during this period. Having more international equity would have given us more decrease in return than decrease in risk.
Conclusion from 3-Component Portfolio, 1996-2013 Holding Period – From this specific analysis, we saw that the most efficient international equity allocation was a meager 10% of your total equity position, much less than the 40% being touted by the literature as being the most efficient point. However, we also saw that having any amount of international equity decreased volatility at the same time as decreasing return, with 10-30% international allocation featuring the greatest decrease in risk (being in this range wouldn’t be the most terrible thing ever!).
Truthfully, I was a little shocked at the results above.
After all, a 10% international equity maximum efficiency is quite a bit than the 40% point that was found by the literature! This got me thinking that either a) the 17 year time period I used was not long enough to capture history in a representative way or b) my calculations are off.
In order to investigate the situation further, I decided to expand the years of my analysis to the time period of 1972-2011, since these were the years covered by Simba’s return data spreadsheet from the Bogleheads forum.
I then modeled the average annual returns during this ~40 year time period of the same 70/30 equity-fixed income allocation portfolio mentioned above at varying levels of international equity exposure (0-60%, as a % of the total equity position). In order to meld the analysis to the data available in the spreadsheet, the 3-components held in the portfolio were the Total US Stock Market (domestic equity position), Total International Market (international equity position), and the Short-Term Treasury Fund (fixed income position).
Shown below is a graph plotting the annual return (y-axis) vs. the risk/volatility/standard deviation (x-axis) at varying levels of international equity exposure, from 0-60% of the total equity holding position. Also pasted below is the table with the data that the graph was constructed from.
In my humble opinion, the graph and data shown above would fall in to what I would call the “beautiful” category. What I mean by this is that it is a textbook example of the magic of diversification and portfolio construction / asset allocation.
Let’s walk through it. Start off at the bottom of the curve, which corresponds to a portfolio having an equity position consisting of 0% international stocks. As we increase the international equity to 10-30% (each point/plot on the graph represents 10% more international equity), we see something amazing – volatility decreases, but average return increases! Pretty sweet, right?!
In fact, the standard deviation of the portfolio does not start increasing back to what it was when we just had US domestic equity until an international equity allocation of 40%! In terms of the maximum return/risk ratio, this data indicates that the most efficient point is when international stocks = 30% of total equity holdings. However, it is also significant to note that if you can tolerate more risk, you would have obtained a higher return with an even greater (40-50%) international allocation level.
If you’re interested in looking through all of the details/numbers of this analysis, you can access the Google Docs spreadsheet by clicking here.
Conclusion from 3-Component Portfolio, 1972-2011 Holding Period – 30% international equity as a percentage of total equity holdings was found to be the most efficient in terms of highest return with lowest risk.
So, after going through all of this investigation comparing varying levels of international equity, what’s the overall verdict? Well, I think it can be summed up in a couple of key-points:
How about you all? What % of your portfolio’s total equity position is invested in international stocks/funds?
Have the movements in the international markets ever caused you to be alarmed/change your strategy, or did you not have that much trouble keeping a long term focus?
Share your experiences by commenting below!
Hi folks! My name is Jacob. I am the owner and operator of My Personal Finance Journey. I started this blog in January of 2010 and have enjoyed the journey ever since. Since finishing up graduate school in Virginia in 2014, I have been working in biopharmaceutical development in Colorado. You can read more about me and this site here. Please contact me if you have any questions!
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