A look at international asset allocation

Bryan Lewis uses the concept of cap weighting to illustrate the significance of international markets. He also discusses how an appropriate international allocation can reduce portfolio volatility.

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Akweli Parker: Our first question comes from James in North Potomac, Maryland. James asks, “What is an appropriate allocation to international stocks and bonds?” So Bryan, I’d have to imagine that you get some variation on this question as you’re working with clients. What do you tell folks?

Bryan Lewis: Absolutely. And I think it’s important to point out Vanguard’s approach to investing. We follow what’s called a market-cap weighting. Essentially what that means, let’s look at stocks. You take a company stock, its price or its value, and you multiply it times the outstanding shares and then it gives a value of that company. If you were to look at stocks and really do that domestically and abroad, you would find of the global stock market about half is US stocks and about half is international stocks. If you look at bonds, international bonds actually represent a larger percentage of the market share than that of the US bond market. In fact, international bonds are the largest asset class out there. So we certainly would want exposure there as well. So Vanguard, we typically recommend of your stock allocation that you have approximately 40% of your stocks invested in international stocks. On the bond side, we typically recommend that you have approximately 30% of your bonds invested in international bonds, and usually the follow up question I get is why? We’ve down extensive research on this and we will continue to do that. And I thought it would be helpful to actually look at stocks, so I actually want to bring up the diversification chart, and this is specifically focusing on the average annualized change in portfolio volatility when including international stocks with a US portfolio, and it’s looking between 1970 and 2016. And there’s three different color lines here and they represent three different asset allocations. So let’s look at the red line just for a simple example. That’s representing a 100% stock portfolio. So if you look on the far left where it shows the 0%, that’s essentially saying that you have 0% of your 100% stock portfolio invested in international stocks. So as you go left to right, you can actually see the lines begin to dip down and, essentially, what this is highlighting is as you introduce international stocks to the portfolio, it’s actually helping over the long run to bring the volatility of your portfolio down; and by volatility, the price fluctuations of the portfolio.

So as you continue to go left to right, you can actually see that the lines begin to go back up and, essentially, what that’s saying is if you begin to introduce too much international exposure, it can actually make the portfolio more volatile which we’d also want to avoid as well. So, I thought this would be helpful.

One of the big things we’ll get into today is around the risk and how to diversify but, over a long period of time, having international stocks within the portfolio has actually proven to bring down the volatility of your portfolio.

Important information

All investing is subject to risk, including the loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.