What's Wrong With Your Portfolio

I still like the idea of "buy-and-hold," although I now believe you should include at least 40% of your portfolio in international stocks. -- Jeremy Siegel

During an economic downturn such as the one we currently face, investors often put their money in cash or other "low-risk" investments. And The World Bank recently reported that although there has been a steep decline in international capital flow to investments because of the recession, they expect foreign investments to fall even more during 2009.

There's a lot of uncertainty right now -- investors are fearful about buying foreign stocks.  Bearing in mind that they're already nervous about buying domestic stocks, which are often thought to offer greater transparency and less risk than their foreign counterparts, that fear is understandable.

Here's what's not understandable
You don't want to let that fear increase your risk and hurt your returns.

The benefits of international diversification have been well-documented, attracting the approval of Vanguard founder Jack Bogle and renowned scholar Jeremy Siegel. While The Wall Street Journal reports that the typical average American mutual fund investor holds just 12% to 15% of his or her portfolio in foreign stocks, the two have urged investors to devote some 20% to 40% of their portfolios to international companies. That's a far cry from our present average allocation.

A recent study by professors Fasnacht and Louberge confirms the wisdom of Bogle and Siegel's advice. Listed below are four of the larger stock markets in the world, and their respective correlation coefficients. Don't let the statistics scare you -- the important thing to note is that a number closer to one means that your investments will move in tandem, and a number closer to zero provides you with better diversification:

Data from January 1, 1973, to March 29, 2006.

As illustrated by the data above, if one were to only invest in, say, the U.S. and Canadian stock markets, he or she would tend to reap similar gains or losses. However, if one were to invest in the U.S. and Japanese stock markets, that person would have a much better chance of spreading out their portfolio risk.

This is especially important because diversification not only can reduce risk, it can also lead to higher returns. Compare the three-decade-plus returns of domestic stocks with an international approach to those with a half-international, half-domestic approach:

Sources: Ibbotson Associates; author's calculations. Domestic stocks: S&P 500; international stocks: Morgan Stanley EAFE.

And this makes sense, doesn't it? Countries tend to have different economic and business cycles -- so by holding equities in more than one country, you receive the benefit of diversification, and the resulting gain in annual returns.

To put this into practice, when you're buying domestic heavyweights like Johnson & Johnson (NYSE:JNJ) and ExxonMobil (NYSE:XOM), for example, it's also worth considering whether you want to own their international counterparts such as Novartis (NYSE:NVS) and Petrobras (NYSE:PBR).

Taking it up a notch
Like developed foreign markets, emerging economies often have low correlations with the U.S. stock market. And they provide other benefits, as well:

• Emerging markets are expected to outperform their more modernized peers in economically important categories such as employment, capital usage, and enhanced productivity. They also have a very important demographic advantage in countries like China with rapidly growing middle classes that will be purchasing increasing amounts of personal goods as their wealth increases. These factors, taken together, provide emerging markets with greater growth potential than industrialized nations.
• Companies in emerging markets are less likely to be followed by a big group of analysts than companies in internationally developed countries. Numerous studies have shown that less widely followed companies have a greater chance of being undervalued.

One way to gain exposure to emerging markets is through ETFs like Vanguard Emerging Markets (VWO), which spreads its bets around the globe to foreign stalwarts like PetroChina (NYSE:PTR), Vale (NYSE:VALE), and  America Movil (NYSE:AMX). While these funds offer diversification, they're often heavily tilted toward large companies that are less dynamic than the three mentioned, and industries that you may or may not be interested in.

Another way to buy into emerging markets is to purchase individual stocks. Choosing a diversified basket of five to 10 dynamic companies with fantastic management and powerful economic tailwinds is a great way to aim to buy the best names emerging markets have to offer while still remaining diversified.

While this will certainly offer an investor a chance to reap substantial gains with many lesser-known companies, it also bears greater risks, including limited transparency, unusual accounting, and unfamiliar managerial practices. Not every emerging-market or international stock is promised to make you big bucks. Choosing the right ones requires that you familiarize yourself with their businesses, as you would with a potential domestic investment. That's why, earlier this month, our Motley Fool Global Gains team of analysts went on a two-week trip to China, where they met with various companies and scoured the rural areas outside of Hohhot and Xian to crack the code on the booming agricultural sector.

If you'd like to see their best investment ideas from the trip, as well as all of their market-beating recommendations, you can join Motley Fool Global Gains, free for 30 days.  Click here for more information.

Fool contributor Jordan DiPietro doesn't own shares of any of the companies mentioned above, but is eagerly waiting to jump on the team's next recommendation. America Movil and Novartis are Motley Fool Global Gains selections. Johnson & Johnson and Petrobras are Income Investor picks. The Fool's disclosure policy has no international boundaries.