International mix can reduce portfolio risk

International stocks have performed better than U.S. stocks over the past few years and some have argued that their period of out-performance might be ending. There may even be calls in coming months for investors to reduce their exposure to international equity.

However, an adequate investment in international stocks should prove essential to a healthy portfolio mix. By performing differently than domestic stocks, foreign stocks have reduced overall investment risk in the past. Moreover, several factors suggest the recent trend for international stocks to perform better than U.S. issues might continue.

One factor that lends support to the belief that international stocks will continue to be attractive in the next year or two is the movement of the dollar over that time. When the dollar falls, as it did in the first half of 2006, the fall benefits the returns of international stocks. Even should stock prices remain unchanged, a lower dollar increases the value of U.S. investments in such stocks.

Although short-term currency movements are difficult to predict, many investors believe the dollar might face significant headwinds relative to other currencies in the next one to two years. The Federal Reserve is likely near the end of its tightening cycle, whereas the Eurozone countries, and even Japan, are likely to continue to raise interest rates. Should this happen, international investors are likely to invest more money in other countries to obtain the relatively higher yields, causing the value of the dollar to fall against other leading currencies.

Diversifying a portfolio with non-U.S. stocks brings with it another potential benefit. International markets provide greater opportunity for money managers to find bargains among stocks undervalued by the market. The U.S. stock market, the most developed market in the world where investors have access to a large amount of company and industry data, is less likely to produce these opportunities.

In addition, pressure from U.S. regulators ensures that senior management is generally more forthcoming than company management in other countries might be. As a result, skillful international managers are better able to exploit the marginal information they gain through research and understanding of the markets.

This opportunity to find stocks at attractive levels is generally considered even greater in the emerging market countries than in the developed countries. These countries also appear to have stronger growth rates. Therefore, such stocks may offer even more benefits.

Although the potential for adding additional returns by including international stocks appears compelling in the near term, diversification benefits remain foremost over longer periods. Diversification is most beneficial when correlation among the asset groups in which the investments are made is low, which means that the two investments usually move in different directions.

True, the correlation between the U.S. and non-U.S. markets has increased over the past decade, resulting in the two markets moving in roughly the same direction more often. However, much of this high correlation took place during the global run-up and subsequent correction of the more speculative technology and telecommunication stocks. Indeed, correlations have risen and fallen over time, but they will continue to provide diversification benefit.

Although several factors support the inclusion of non-U.S. stocks, foreign markets also bring increased risk.

For example, although the lack of information on international stocks can provide opportunity for diligent investors, it poses a material challenge to those with fewer resources.

Also, investors in non-U.S. stocks potentially take on political risk, which has posed particular challenges in the emerging markets over the years. An election in a country might change the economic system, for example, with dramatic results on the stock market in that country.

Despite these potentially negative factors, the majority of managers monitored by Russell continue to believe international stocks should remain an essential component of most investment strategies.