The Biggest Threat to Your Portfolio Today

CBS flew me to New York and put me up in a tony midtown hotel recently so I could appear on The Early Show. The topic? What investors can do to cope with this economic "fiasco" -- Harry Smith's word, not mine.

During the pre-interview, Smith asked me point-blank, "Tim, where is the safest place for our money?" I told him that while it depends on your timeline, if this truly is money that you don't need for the next 10 years or more, then the safest place is foreign stocks.

He shot me a look and said, "I'm going to challenge you on that."

Never happened
Television being what it is, he never did get around to challenging that assertion. (I've never yet been part of a segment that didn't get cut short.) I wish he had.

Take China, for example. Though its growth is slowing, it's still expected to grow 7% to 9% per year for the next decade. This is why Princeton economist Burton Malkiel wrote in his most recent book on investing that "the biggest risk to any investor's portfolio today is not to have at least some exposure to China."

But an even bigger risk -- nay, threat -- is that you don't have any exposure to any other countries at all!

Here's why
Most Americans are dramatically underexposed to foreign markets. While there's no consensus as to how much foreign exposure the average American has, estimates range from 2% (dangerously low) to 20% (slightly low). This has two significant consequences.

First, it leaves you especially vulnerable to a slowing U.S. economy. Today, for example, as you're watching the value of your home drop, you're seeing your stock portfolio decline and your hard-earned dollar buy less and less. Even worse, given our weakening economy, your job prospects may be dimmer than they were this time last year.

Second, when you ignore foreign markets, you're all but assuring that you are going to miss out on the greatest economic growth of the next 10 to 15 years. Given development trends, I believe China, India, and Brazil all stand to outgrow the U.S. going forward by significant margins. Other emerging countries such as Vietnam, Indonesia, Colombia, Mexico, Thailand, the Philippines, and Poland also have that potential, though their futures are a bit harder to predict, given additional political and economic uncertainty.

The good news is you can buy exposure to all of these countries in your portfolio, thus increasing returns and reducing volatility in the process.

How much is enough?
I'm not the only crazed investment analyst who's advocating that American investors take advantage of current volatility to beef up their exposure to promising international stocks.

In October, Ibbotson Associates recommended that American investors should invest 35% of their portfolios abroad, with at least a third of that allocation devoted to the emerging markets. Citigroup one-upped that plan when the advisor told its clients recently to up their international exposure to 55%. And one of the smartest investors around, PIMCO co-CEO Mohamed El-Erian, told Money magazine: "The world of tomorrow suggests a much greater exposure overseas. ... [Y]ou should consider holding a third of your equities in the U.S., a third in industrial countries outside the U.S., and a third in emerging markets."

Add that up and El-Erian believes American investors should devote a hearty 66% of their portfolios to foreign stocks!

Which brings us to ...
The good news is that if you've been reading along and now find yourself convinced that you're underexposed to foreign stocks, this is a good time to make it right. Foreign stock markets -- and particularly the emerging markets -- have suffered this year as slowing growth has led investors to abandon shares that were previously trading at very premium valuations.

And today, for example, some of the world's fastest-growing names have not only seen their valuations come down, but also their spreads narrow relative to their slower-growing American peers:

Data from Capital IQ, a division of Standard & Poor's. Multiples are normalized where necessary.

While growth abroad is slowing, it is certainly not stopping, and the valuations on emerging stocks today give you a much better chance of making money than they did just 12 months ago.

To recap
By now you should know:

1. You need foreign stocks in your portfolio.
2. You don't have enough of them.
3. Now is a good time to buy them.

You can, of course, gain exposure to foreign markets through a host of low-cost ETFs and mutual funds. But if you're looking for the best of the best, try our Motley Fool Global Gains investment service -- free for 30 days. We recommend two new stocks every month, as well as our best bets for new money now. Just click here to get started. There's no obligation to subscribe.

This article was first published Oct. 2, 2008. It has been updated.

Tim Hanson does not own shares of any company mentioned. Wal-Mart de Mexico is a Motley Fool Global Gains recommendation. Wal-Mart is an Inside Value selection. SINA is a Stock Advisor pick. The Fool's disclosure policy recommends you garnish your gin and tonic with a sprig of basil rather than a slice of lime. It really is quite a refreshing combination.