The benefit of international investmentsInvesting in multinational U.S.-based companies may offer some diversification benefit. Scott Donaldson of Vanguard Investment Strategy Group and Bryan Lewis of Vanguard Personal Advisor Services® say only by investing in non-U.S. equities do investors gain the full benefit of added diversification. Vanguard recommends investing 20% to 40% of your portfolio in non-U.S. markets.
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TRANSCRIPTAmy Chain: Let’s take another live question that we got, back to talking about international investing. This one comes from Charlie. Charlie, thank you so much for your question. Charlie asks, “Regarding international allocation, what about the statement that the US-based stocks are already heavily invested in global areas like Coca-Cola that are available on a worldwide basis?”
Bryan Lewis: I get that question on a weekly basis. It’s the idea of multinationals, Coca-Cola, McDonalds, Pepsi. They generate a lot of the revenue overseas, and when I create financial plans or I’m having a discussion with the client and talking through Vanguard’s allocation for international, we get into the details of this. You know, there’s a few things you have to account for. So in the international markets, you have to think of, there’s some currency benefits potentially to that. But, more importantly, the U.S. is very heavy in IT, biotech. When you start looking at some of these international markets, they are very old-world industry. As far as exposures, you think of automobile, consumer goods. So if you’re, in a sense, excluding the international markets, you’re giving up Nestle, you’re giving up Toyota. Automobile is a big exposure overseas as well, so you’re giving up pretty much half the world as far as the exposure, especially when you start looking at the global market cap, which is roughly half and half, half U.S., half international. So it’s something you need to consider.
Scott Donaldson: We’ve done a lot of research on this as well in my group, and the one thing that I think people forget about and a lot of the data shows the true. There are many, many huge multinationals that have huge exposures to foreign earnings that are driven from the different countries and so forth. So there certainly is exposure there. However, as far as the performance of the stocks, a lot of the data shows that the performance is driven more by where the stock trades; and it acts more like the market of where it’s trading versus everybody always looking through to where their earnings are coming from. And if, say, Brazil is up, their market’s up, and half of a company’s earnings come from Brazil, that stock, most likely, is not up if the U.S. market is down, if it’s trading on the U.S. market.
Amy Chain: So what do we think investors should do knowing that information?
Scott Donaldson: They should be broadly diversified across U.S. equities as well as non-US equities to the tune that Bryan highlighted, up to 40% of their portfolio on the equity side. And on the international bond side, which we haven’t talked about, should be as well up to say 30% of their bond portfolio, but the key difference there is on a hedged basis. So looking at portfolios that actually hedge the currency risk out because—
Amy Chain: Define it for us.
Scott Donaldson: Anytime you’re investing internationally, an investor in the U.S. buying say United Kingdom stock, the dollars have to be converted in the local currency in order to buy that. In order to spend that money, that currency has to be converted back to US dollars. So there’s an exchange rate, okay.
Amy Chain: So if you’re buying an unhedged security, you’re betting not only on a security but also on the currency.
Scott Donaldson: You are, right. So hedging the returns and the exposures back to the US dollar basically takes that currency play out of it and gives the pure exposure just to the underlying fixed income performance and actually getting to that broad diversification. And, actually, I think it’s a good time, I’d like to bring up a chart to kind of add to this. There’s a market cycle chart that we can show, and this is a very interesting chart. And as you first look at this chart, you’ll notice there’s a lot going on here. And don’t worry that you can’t read any of the particular words, but I do want everybody to focus on all of the different colors. And what this chart shows—
Amy Chain: It looks like a bowl of Skittles to me.
Scott Donaldson: Yes, what this chart shows is an annual ranking of best performing asset classes, both global as well as U.S., various sectors, ranked from best to worst in several years looking backward. What you will notice, or in this case maybe not notice, there are no particular trends that can be highlighted here. It’s all over the board, so one year you have international stocks doing well, the next year not. You might have large growth doing well one year, the very next year not doing particularly well. I’d like to call this, I’ve heard it, I’ve called it, heard it called the periodic table, right? I’ve heard it called the quilt chart. Now we’re going to refer to it as the bowl of Skittles. I like to call it the first to worst or the worst to first chart, and here’s an example of why I think that. Let’s pull up one more chart on emerging markets to give you a highlight of, this is why it’s important to diversify, okay, is on a regular basis the market leadership changes. And here’s an example that in any particular year you notice emerging market equities were the worst performing in some years and then very quickly changed to the outperforming or the best performing asset class and then back to the worst again. So the key to being broadly diversified across both U.S. and international stocks, and that’s not just across those particulars, but within the U.S. and within international stocks, you should also really own all aspects of those particular markets. You should own large-cap, you should own small-cap, growth, value, and that’s because all of your portfolio then or a good chunk of your portfolio is never exposed to the worst performing asset class, and you’re always going to have some exposure to the outperforming asset class. So by definition, that is diversification.
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Currency hedging risk is the chance that currency hedging transactions may not perfectly offset a security’s foreign currency exposures and may eliminate any chance for a security to benefit from favorable fluctuations in relevant currency exchange rates. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
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