Keep Foreign Stock Exposure Small

Investing overseas has been all the rage for a while. It makes sense to diversify beyond the United States, but only up to a point.
How much of your portfolio should be in foreign stocks? A rough target is 17%, far below what most experts tell you.
Last year, amid a banking crisis in Europe and a slower pace in China’s pell-mell growth, foreign markets fell by double digits. The MSCI Europe Australasia and Far East Index, or EAFE, covering the developed world outside North America, dropped 11.7%. The MSCI Emerging Markets Index slumped even more, 18.4%. Meanwhile, the Standard & Poor’s 500, which tracks large U.S. stocks, was flat.
This raises the obvious question whether international investments continue to make sense for the long term.
Prior to 2011, some investment gurus advocated for large foreign market allocations, convinced that the U.S. was in decline and that the dollar would collapse. They repeatedly chastised myopic Americans for failing to notice that the $15 trillion U.S. stock market was now only one-third of the $49 trillion in publicly traded equities worldwide (down from two-thirds 20 years ago).
Some suggested that portfolio allocations should reflect these global ratios, with around two-thirds invested outside of the United States. Developing economies, such as those of China, India and Brazil, got a lot of attention. They sported rapid growth and increasingly large stock markets.
Until 2011, this hyper-global investment philosophy seemed to work well since foreign markets – particularly in the developing countries – significantly outperformed the U.S. stock market. Although foreign markets in early 2012 have made a comeback from last year amid signs that the European crisis may be resolved, problems abound overseas. (EAFE is up 11.3% and the emerging markets benchmark 15%), Europe teeters on the brink of recession and China still faces slower growth.
Here’s why it makes sense to limit foreign exposure. The United States continues to offer the widest array of investment possibilities relative to other countries while providing the best legal protection for your capital. Many foreign countries are just now starting to develop an appropriate rule of law to protect investors. This statement applies to some developed countries such as Italy, not just low-income emerging markets like China.
So that 17% target for investments abroad offers appropriate diversification. If the legal protections for investors improve overseas and the euro zone countries address their fiscal problems, then raising this allocation over time would be warranted.
Meanwhile, U.S. stocks are attractively valued, given the prevailing pessimism in the world today. The S&P 500 has a trailing price/earnings ratio of 15, in line with its historical average.
Worries about an escalating European financial crisis exacerbated stock market volatility in the U.S., but fears exceeded reality by a wide margin. The facts on the ground continued to improve slowly in America, further extending the economic recovery that began nearly three years ago. Even though indicators are moving higher in the United States, it will take many years before the domestic economy returns to the levels of employment, lending and construction achieved prior to the Great Recession of 2008-2009.
The general picture is of an economy moving away from financial crisis lows but still quite far from full recovery. Investor psychology remains fearful of further crisis and potential collapse. As time passes and the U.S. economy continues to heal, market psychology should better reflect economic reality.
Brian J. Friedman is president of GHP Investment Advisors Inc. in Denver.
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