If only you'd listened.
Two years ago, Wharton finance professor and investing sage Jeremy Siegel raised eyebrows when he suggested that American investors keep 40 percent of their stock holdings in foreign shares—more than double what the average investor owned at the time.
If you had followed his advice and traded in, say, an index fund tracking the S&P 500 for one that follows the global markets (like Vanguard's Total International Stock Index Fund), you'd have more than doubled your gains. If you had stuck your neck out a bit further and bought into, say, an index fund that tracks emerging markets (like Vanguard's Emerging Markets Index), you'd have trounced the S&P fourfold—and doubled your money.
Still, even if you're taking the slow boat to China, it's not too late to hit the water. Part of the reason is the continuing decline of the U.S. dollar, which makes stocks denominated in foreign currencies more valuable regardless of how they perform. With the dollar seeming to hit new lows against the euro and yen almost daily—and further declines predicted, especially if the U.S. economy slips into recession—you might think of an investment in foreign stocks as coming along with a built-in currency hedge, at least for now.
But there are even more important reasons and smart ways to invest overseas for the long haul. Here are six of them:
• It's the global economy, stupid. Back in 1998, Federal Reserve Chairman Alan Greenspan gave a now famous speech in which he warned that it was "just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress." The "stress" to which Greenspan was referring was the ongoing fallout from the 1997 Asian financial crisis.
Now, a decade later, the situation seems more the opposite. It's the American economy that's under considerable stress—thanks to the bursting housing bubble and credit crunch—amid a booming, prosperous global economy. The International Monetary Fund is forecasting the world economy to expand at a red-hot 4.8 percent this year and next, as the Chinese and Indian economies surge. U.S. Treasury Secretary Henry Paulson calls it "far and away the strongest global economy I've seen in my business lifetime."
Hyperbole? More like understatement. Paulson's old firm, Goldman Sachs, says 2003 through 2008 should prove to be "one of the most powerful periods of economic growth globally since accurate data [have] been collectible for much of the world."
The major reason for the boom, of course, is the global expansion of capitalism and trade that followed the end of the Cold War. Suddenly, a tremendous amount of underused human potential and productivity—and buying power—began to emerge. "I believe the fall of communism and the reintegration of billions of people in the global economy is the biggest economic event of my life," says Brent Lynn, portfolio manager of the Janus Overseas Fund.
But the global boom isn't just about emerging markets. The mainstream economies of Europe and Japan are strong again, and for the first time, the total value of the European stock markets recently surpassed that of U.S. markets.
• Americans underinvest overseas. The reason, say economists, is the same fear of the unknown that has long kept two thirds of Americans from traveling abroad. Its roots are largely irrational. Hostile foreign governments, for instance, might seize the assets of private companies, as Venezuela did recently—yet the companies most affected were based in the United States, not other countries. U.S. investors also tend to feel that foreign accounting and legal standards are below those in the United States—in spite of the American-produced Enron and WorldCom debacles. Or they worry that financial information about foreign companies is simply too hard to come by, even though Reuters, the Financial Times, and others have it covered.
• Foreign investing is a smart way to diversify. With such a large portion of the world's public companies now overseas, leaving them out of your portfolio is "like saying, 'I'm only going to invest in companies with names that start with A through F,'" says Wharton's Siegel. Even emerging markets, he notes, boast large, well-run firms like Petro-China—Asia's most profitable company—and South Korea's Samsung Electronics.
Siegel advocates a big stake in foreign equities not because of their potential for heftier annual returns but because they can lower your portfolio's risk. Global stock markets do tend to move together over the short run, as in the sell-off in August and the subsequent bounce back after the Federal Reserve lowered interest rates last month. But "there's no correlation between them over the long run at all," explains Siegel. "So by diversifying globally, you're spreading your bets and reducing your risk."
• It's best to raise your foreign holdings gradually. With the recent run-up in global stock indexes—all at a time when some economic indicators point to a global slowdown—many financial advisers suggest using a classic dollar-cost averaging strategy (buying shares at regular intervals) to build a foreign portfolio over time. "That way, you don't have to worry about getting in at the peak," Siegel says.
The first order of business is figuring out exactly how much foreign stock exposure you have and settling on an appropriate proportion. Most brokerages offer online programs that automatically track your diversification. But be sure to check your U.S. mutual funds, too. According to Morningstar, the average U.S. fund now holds about 7.4 percent in foreign equities.
So what's the right amount? That depends on your time horizon and tolerance for risk. Investing in companies in emerging markets can come with added risk over the short term. The thing is, unlike the modest growth in developed economies, "these [emerging] markets are still growth markets," says Sarah Ketterer of the $5 billion Causeway International Value Fund, who keeps about 10 percent of her personal portfolio in emerging markets. "And that will probably rise given the way they're performing."
Of course, if you plan to retire soon or think you'll need to cash out, say, to make a down payment on a house, holding a substantial portion of your wealth in foreign currencies does represent a risk.
• Divvy up foreign stocks just as you would a U.S. portfolio. Given the huge stock returns generated by some emerging economies, you might be tempted to make a big bet on the flashiest play. But again, you should spread your bets overseas just as you would here at home. "You never put all your eggs in one basket, especially the hottest basket," says Antoine van Agtmael, chief investment officer at Emerging Markets Management. "Right now the hottest basket is China." Van Agtmael has put some $20 billion to work in a broad spectrum of markets, including Brazil, Mexico, the Czech Republic, Slovakia, Dubai, and Nigeria. "We try to not be in the middle of the party but a little bit on the side of the party."
Jonathan Clements, author of 25 Myths You've Got to Avoid—If You Want to Manage Your Money Right, suggests putting half of your foreign holdings in blue-chip stocks from developed countries (such as the iShares MSCI EAFE-based index fund), then splitting the rest evenly between an emerging-market index (like the iShares Emerging Markets Index) and a small-cap stock fund (such as T. Rowe Price's International Discovery Fund). He and Siegel both favor broadly diversified funds, such as Vanguard's Total International Stock Index Fund, an amalgam of its European, Pacific, and emerging-markets funds.
• For once, don't hedge! Whichever funds you choose, Clements advises, "make sure they don't hedge their currency exposure." Hedging, after all, would dilute the benefits of investing overseas. "Half the benefit of owning foreign stocks," Clements notes, "is that you can diversify the currencies you hold." Then, weak dollar or no, you'll have plenty of pesos to spend when you retire to that Mexican villa.