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Course 510
What's the Right Foreign Allocation?

Introduction

It's a trend we've seen again and again: Investors' enthusiasm for an asset class seems to ebb and flow with the performance of that market segment.

Foreign stocks are no exception. For example, though there are sound fundamental reasons for investing in emerging markets, it's probably not a coincidence that investors send scads of new money to diversified emerging-markets stock funds when they are outperforming.

But rather than adding to and subtracting from your foreign stake based on market performance, and risk being whipped around by market winds, a better approach is to set a strategic, long-term allocation to foreign stocks and stick with it, making only minor adjustments to rebalance.

Unfortunately, that's easier said than done. Even informed observers vary widely on how much to stake overseas, ranging from the "don't bother" camp to the "all global, all the time" school of thought.

And importantly, classifying foreign and U.S. companies based on where their headquarters are located is evolving into an increasingly questionable exercise, especially for large-cap multinationals. Companies such as Coca Cola and McDonald’s derive more than half of their revenues from overseas, whereas global behemoths such Nestle and Toyota count on the U.S. for a big portion of their sales.

The Global Portfolio: A Starting Point

Given the fact that country of domicile doesn't say a lot about where a company actually does business, it's tempting to shelve the foreign versus U.S. allocation question altogether and simply opt for a global markets index fund.

That's a logical approach, particularly for those who are already index enthusiasts. If you buy into the concept of letting the market decide the size of the holdings in your fund, letting the market decide country weightings is a logical extension of that thought process.

And even if you're not ready to cede complete control of your country allocations by investing in a global stock market index fund, the geographic allocations of the global market provide a good starting point for thinking about your own allocations. Consult the allocations of an index such as the FTSE All-World Index, for instance.

Ask the Experts

Morningstar's Lifetime Allocation Indexes, developed in conjunction with asset-allocation specialist Ibbotson Associates, provide additional intelligence about what's a reasonable foreign/domestic split.

In general, it's worth noting that these benchmarks are much less foreign-stock-heavy than is the case with global market benchmarks such as the FTSE All-World Index. For example, the portfolios geared toward investors who are just starting out steer roughly 40% of their equity assets toward foreign stocks as of this writing, and those weightings step down dramatically for those nearing and in retirement. For people with 10-15 years until retirement, the indexes' foreign stakes compose roughly 30% of the overall equity allocation as of this writing, and drop to 20%-25% of equity for those who are already retired.

One of the key rationales for a lower foreign-stock allocation in retirement is currency risk. Because foreign assets are not denominated in dollars, there's a chance that foreign currencies could dip as an investor approaches retirement, thereby depressing the purchasing power of a heavily globalized portfolio at an inopportune time. Of course, those currency swings can work the other way, too. But the bottom line is that currency risk is a wild card that's completely out of your control, and you're better off reducing any such risks as retirement draws near.

A checkup of target-date funds' average foreign allocations yields weightings that are in a similar range, roughly one third of the overall equity portfolio as of this writing. As is the case with Morningstar's Lifetime Allocation Indexes, foreign stocks consume a larger share (close to 40%) of the equity portfolios for younger investors than is the case for investors closing in on retirement.

Quiz 510
There is only one correct answer to each question.

1 How should you determine what your foreign allocation should be?
a. Add or subtract foreign exposure based on market performance
b. Set a strategic, long-term allocation to foreign stocks and stick with it, making only minor adjustments to rebalance
c. U.S. investors should not invest in foreign stocks under any circumstances
2 What factor complicates the decision of how much your foreign allocation should be?
a. Informed observers vary widely on how much to stake overseas.
b. Country of domicile doesn't say a lot about where a company actually does business
c. Both A and B
3 What can global market index funds provide investors?
a. An easy way to gain exposure to all markets around the globe in one investment
b. Ideas for how to determine your own foreign allocation
c. Both A and B
4 Who is a global market index fund best suited for?
a. Investors who want to decide their own regional and country weightings
b. Investors who want the market to decide regional and country weightings
c. No one – they are poor investment choices
5 Why do many target-date funds and indexes allocate a smaller percentage of assets to foreign stocks as investors near retirement?
a. Because of currency risk
b. Because investors nearing retirement should own cash
c. Because U.S. stocks are better opportunities
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