The Importance of International Diversification

Barring some client specific constraint, at Parsec we give each portfolio we manage exposure to international markets. The appropriate amount of international exposure is debatable and the merits to this exposure are not without dispute. However, we believe the benefits are worthwhile.

There are downsides to international investing. First and foremost is the cost associated with it. These costs come in the form of higher transactions costs, informational inefficiencies (you may pay too much in a foreign market because you don’t have all the relevant information to make the right decision), and various tax disadvantages. In addition, opponents argue that our global economy means that holding stock in big corporations like GE and Coke will give you all the international exposure you need without the extra cost. Indeed, these companies do offer some global diversification.

However, there are benefits to investing in foreign-domiciled countries that I believe trump these arguments. The first and foremost of these is the less than perfect correlation between US stocks and foreign-domiciled stocks. Though correlation is rising, especially during times of high volatility, there are still correlation benefits. In other words, when US stocks zig, foreign stocks will sometimes zag. The benefit to the investor is an overall reduction of risk, without the reduction of return.

This benefit is enhanced with emerging foreign markets that have much lower correlation with US stocks than larger developed foreign markets such as Europe. The caution with investing in African countries, the Middle East, Latin America, Russia, China and India, however, is the risk is also much greater, so you have to be careful about adding too much to a portfolio. A little exposure may give you a desirable return/risk benefit, but too much can substantially increase the risk to your portfolio. The outcome is heavily dependent on how the emerging market is correlated with the US, and the stand-alone risk of the emerging market itself.

Some common ways to get exposure to international markets are through passive index funds, active mutual funds and by directly buying stock if it is traded on a US exchange (ADR). Though sometimes we buy ADRs, we most heavily rely on actively managed mutual funds. There is a cost associated with this, but we believe the best managers, who are experts in their chosen markets, are skilled at finding profitable companies in international markets.

Whether the equities portion of a portfolio is 10% international or 25% international, we believe that some exposure is warranted. Emerging markets add another beneficial layer of diversification. It is impossible to know in advance what the exact country-specific exposure should be, but we are confident that adding some small portion of the markets outside the US will improve the long-term risk-return characteristics of a portfolio.

Harli L. Palme, CFP®

Financial Advisor

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