Take Your Portfolio on Vacation

As a nation, we are geologically blessed to have an almost endless supply of unique travel destinations. From the crystal sands and azure waters of the Florida Gulf Coast to the majestic snowcapped mountain ranges of Alaska, there's enough to fill the itinerary of even the most ambitious traveler. Nevertheless, many of us still feel compelled to visit places well beyond our borders. Despite the vast array of travel choices here at home, there will always be many more waiting at the far corners of the globe.

Similarly, while a host of world-class companies are proud to call America home, solid firms located on foreign soil should not be overlooked, either. Given the rich diversity of the world's stock markets, investors who cast a wider net will encounter a great abundance of exciting investment options overseas. Strangely, though, the desire to broaden our horizons does not always extend to our portfolios.

It's not surprising that American investors are inherently more drawn to a stalwart U.S.-based company with familiar products -- such as, say, Anheuser-Busch (NYSE:BUD) -- than an unknown firm with an unpronounceable name trading somewhere in Kazakhstan. Still, there is a distinct difference between preferring domestic equities and avoiding foreign ones. Unfortunately, many of us seem to be doing both -- as evidenced by a paltry 3% international equity weighting inside the average 401(k) plan. Meanwhile, those who oversee the nation's 200 largest multibillion-dollar corporate pension plans have directed 16% of their assets to foreign stocks.

Clearly, some of the most elite money managers in the industry are big fans of sampling what overseas exchanges have to offer. Likewise, many financial advisors routinely recommend a 10%-20% foreign exposure (depending on the circumstances, of course) to their retail clients. Motley Fool Champion Funds chief analyst Shannon Zimmerman has allocated more than a fifth of his aggressive model portfolio to international securities (including the foreign holdings of domestic funds).

Why is it, then, that so many investors deliberately choose to underweight the international component of their portfolios? Several theories have been put forth; here are some of the most popular misconceptions:

Not enough diversification
Should our economy falter, crimping corporate profits and derailing domestic stocks, there are likely going to be safe ports in some of the world's other harbors in which to weather the storm. Whenever our markets zig, then others may zag -- negative correlation, as the experts like to call it. However, some contrarians have downplayed this effect, claiming that nearly everyone is affected by the same global economy, so if one nation sneezes, then it won't be long before many others catch a cold.

To a certain extent, there is a grain of truth in this, and large-cap companies in some of the world's more established markets do tend to move in sync with our own blue chips. Yet many insist that those same blue chips -- such as widely held General Electric (NYSE:GE) and Microsoft (NASDAQ:MSFT) -- provide all the international exposure the average investor needs. Clearly, both are stable, home-grown multinationals that derive a significant portion of revenues from overseas operations, but they also usually march almost in lockstep with the S&P, negating any diversification benefits.

Nevertheless, for investors reluctant to keep all their investment eggs in the same basket, foreign markets can help spread the risk. According to a study conducted by Fidelity Investments, over the past 35 years, down months on the S&P 500 have been offset by positive performance on the MSCI EAFE Index (the best proxy for international equities) almost 40% of the time. To cover all the bases, consider foreign bonds or small caps -- two asset classes that have shown very little inclination to move in tandem with our markets.

For example, while many domestic funds have remained underwater over the past five years thanks to the ravaging effects of the last bear market, First Eagle Overseas (FUND:SGOVX) could have provided some much-needed buoyancy. In scouring the globe for undervalued small/mid-cap firms, the fund has posted positive returns in all five calendar years (and in all but four quarters since 1998), delivering compounded annual returns of approximately 17%. Unfortunately, this particular fund has closed to new investors, but other high-quality choices abound.

Foreign stocks are extremely risky
For years, many people have mistakenly bought into the notion that international investing is fraught with danger and best left to more sophisticated investors. To be sure, foreign securities do carry an added set of risks -- our own Bill Mann has outlined some of them here and here -- and those who invest abroad must sometimes face geopolitical uncertainty, currency fluctuations, different accounting and financial reporting standards, and economic instability. Even in developed markets where some of these concerns are minimal, investors still lack the regulatory oversight and protection of the Securities and Exchange Commission.

That said, studies have conclusively shown that adding an international component to the asset-allocation mix can actually decrease overall portfolio volatility -- counterintuitive though it may seem. Proponents of the Efficient Frontier Theory -- a branch of portfolio science that attempts to construct optimum risk/reward profiles -- can tell you that over the past three decades, a 30% international weighting has reduced portfolio risk (as measured by standard deviation) by 10%, without sacrificing anything in the way of return.

Let's face it, though. Those whose knowledge of overseas culture is limited to Clark Griswold's exploits in European Vacation probably don't have their finger on the pulse of foreign markets. Anyone unnerved at the thought of treading in such unfamiliar territory may want to hand over the reins to someone who is skilled in navigating foreign waters. An experienced mutual fund manager can be your strongest ally and can inject your portfolio with a broad cross-section of leading firms from around the world -- without subjecting it to undue volatility.

International returns can't compete
Like two rival football teams that have been squaring off for decades, foreign and domestic equities have taken turns as the victor. During the bull market of the late 1990s, domestic stocks (aided by a surging dollar) powered forward, and those in international markets simply couldn't keep pace. Naturally, money chased performance, and by the end of the millennium, around $90 was flowing into domestic equity mutual funds for every $1 in assets that trickled into their international counterparts.

However, at other times, domestic returns have been clobbered by those elsewhere around the globe. In fact, in the five years leading up to the 1990s, the MSCI EAFE index outran the S&P by some 200% cumulatively, capping off an international winning streak that first began in the 1970s. Things have come full circle recently, as a falling dollar has augmented already strong foreign performance, allowing international stocks to shine once again.

Over the past three years, the average international stock fund has returned a handsome 40% gain to shareholders, trouncing the meager 15% delivered by the typical domestic stock fund over the same period. Since its selection last June, Dodge & Cox International Stock (FUND:DODFX) has raced to near the top of the Champion Funds leader board. Paced by GlaxoSmithKline (NYSE:GSK), Royal Dutch Petroleum (NYSE:RD), and other global giants selected through careful bottom-up, company-by-company analysis, the fund has racked up a stellar 35% gain -- quadrupling the S&P's 9.6% return.

Admittedly, short-term track records can be deceptive, but clearly it pays to have international exposure when the time is right. Here is a quick recap of how our markets have stacked up against others in recent years:

Putting it all together
At one time, gold-seeking investors needed only to dig in their own backyard. Today, though, about three-fourths of the world's largest firms (and plenty of smaller ones) are located abroad, including three of the five largest insurance firms, three of the five largest automobile companies, and four of the five largest food and drug retailers.

In fact, companies listed on foreign exchanges now represent half of the world's total market capitalization -- so building a well-rounded portfolio without foreign equities is like filling a shopping cart by shopping in only the even-numbered aisles.

With a larger pool of stocks to choose from, investors of all philosophies can find something to their liking overseas. Those from the school of value may want to brush up on their French, as Paris' CAC 40 Index is trading at just 13 times earnings. Fans of growth might want to catch the next flight to Austria, where stocks have surged 50% in the past 12 months. And income-oriented investors need not even pack their bags to earn the generous 3.6% average yield of Asian companies that conveniently trade on our own exchanges as American Depositary Receipts (ADRs).

Regardless of your itinerary, choose an exciting destination for your portfolio and enjoy the trip!

Champion Funds' chief Shannon Zimmerman is always on the prowl for the best mutual funds for your portfolio. Want to see which ones have caught his eye? Take a free, no-obligation trial today.

Fool contributor Nathan Slaughter owns none of the companies mentioned but wouldn't mind visiting some of their homelands. The Motley Fool has a disclosure policy.