Optimizing Global Diversification: S&P 500 and International Investments

(Source: Fidelity.com)

Is your investment portfolio diversified internationally? Have you considered including an S&P 500 index fund in your investment strategy? If you answered yes to the latter question, then your portfolio automatically gains international exposure. Let's delve deeper into this renowned chart to gain a better understanding.

(Source: marketwatch.com)

A remarkable fact to consider is that nearly half of the total revenues generated by S&P 500 companies now originate from sources outside the United States. This global reach signifies that the stock performance of these companies is intricately intertwined with their international market performance. Consequently, their economic prospects are closely tied to the prevailing trends and conditions in these overseas nations, making it crucial for investors to keep a keen eye on international developments when assessing the S&P 500's trajectory.

Question: Can investing in the S&P 500 alone provide adequate international exposure? 

While the S&P 500 does offer a degree of international exposure through its constituent companies, it's important to recognize that this exposure may not be comprehensive. To illustrate this, take a look at the visual representation below, which depicts the comparative market capitalization of global stock markets.

The United States accounts for a substantial 53% of the total global stock market capitalization. It's evident that by solely investing in the US stock market, you could potentially miss out on approximately 47% of the world's stock market opportunities. 

Diversifying your investment portfolio is a primary reason for considering international stocks. Diversification isn't always about pursuing the highest returns; it's primarily a strategy to manage and mitigate risk while aiming for a reasonable return on your investments. One classic method for diversification is to include bonds in your portfolio. While bonds may not necessarily promise superior long-term returns, they play a crucial role in reducing risk and serving as a financial safety net. 

Additionally, investing in international stocks serves as an effective buffer against potential downturns in the US stock market, bolstering the resilience of your overall investment strategy.

(Source: Bogleheads.org)

Certainly, diversifying your investment portfolio is not limited to the confines of your home country. In this discussion, we'll focus primarily on the exciting realm of international stock investments. Forthcoming, we may delve into the world of international bonds in another article.

International stocks can be broadly categorized into two distinct groups: Developed market funds and emerging market funds. These classifications encompass the equities of virtually any country, making it easier to navigate the international investment landscape.

Emerging market funds, in particular, are a compelling category. These funds venture into the economies of emerging nations such as Brazil, Russia, India, Taiwan, China, and South Africa. It's important to note that investing in emerging markets carries a heightened level of risk, encompassing geopolitical instability, governance challenges, liquidity constraints, and socioeconomic variables. Yet, this elevated risk profile often presents the potential for more substantial rewards, making it an attractive prospect for adventurous investors.

One key aspect to consider is the lower correlation (0.82) between emerging market funds and the broader US market. This lower correlation signifies that these investments can contribute significantly to diversifying your portfolio. By adding emerging market investments to your repertoire, you can potentially bolster your portfolio's resilience and tap into the growth opportunities offered by these dynamic and rapidly evolving economies.

It's essential to understand the nuances of developed market funds when crafting a diversified investment strategy. These funds, often characterized by their stability and maturity, primarily allocate investments into economically advanced nations. Some of the notable members of this category include Japan, the United Kingdom, Canada, France, Germany, Switzerland, and Australia, to name a few.

When compared to emerging markets, investing in developed markets is generally considered to be less risky. These economies boast well-established regulatory systems, strong corporate governance, and robust infrastructure, offering a greater degree of predictability and safety for investors. The lower level of risk makes them an appealing choice for those seeking more stability in their investment portfolio.

One significant aspect to consider is the higher correlation (0.86) between developed market funds and the broader US market. This indicates a stronger alignment in terms of performance with the US market, though to a somewhat lesser extent than emerging markets. This correlation, albeit higher, still affords an element of diversification, enriching your portfolio by introducing assets that can react differently to market dynamics.

Incorporating developed market funds into your investment strategy can complement your portfolio by providing stability and reliability, thereby balancing the potential risks associated with emerging markets. This multi-pronged approach ensures a well-rounded investment portfolio that caters to a spectrum of risk profiles and investment objectives.

The realm of international stock investments offers even more granularity, enabling you to finely tailor your portfolio to specific regions or countries. For instance, investment giants like Vanguard and iShares provide opportunities to further refine your global investment strategy.

Vanguard, for example, offers distinct funds that target specific regions, such as the Pacific and Europe. This level of specialization enables investors to hone in on the unique economic dynamics and opportunities within these regions, making it possible to fine-tune their investment approach.

On the other hand, iShares, renowned for its extensive exchange-traded fund (ETF) offerings, provides an array of ETFs, each focused on a specific country or market. This is particularly advantageous for investors seeking exposure to a particular nation. For instance, the iShares MSCI Canada ETF caters specifically to those interested in the Canadian market, allowing for a more concentrated investment in a specific geography.

These ETFs and specialized funds serve as valuable tools for those who wish to strategically diversify their portfolios, capitalizing on the potential growth and opportunities inherent to individual regions or countries. By leveraging these options, investors can take a targeted approach to international investing, optimizing their exposure and capitalizing on specific market conditions.

Emerging markets are undeniably among the most dynamic and rapidly expanding economies on the global stage. Investing in these fast-growing economies can hold the promise of delivering superior returns, thanks to the ample growth opportunities they offer.

It's important to note that, historically, the US stock market has often outperformed international stocks when looking at long-term averages. Nevertheless, there's a crucial insight to glean here. Over the past three decades, it's worth mentioning that the best-performing stock market, during any given year, has consistently been located outside the United States.

This revelation underscores the potential advantages of diversifying your investment portfolio beyond domestic borders. While the US stock market remains robust, the global landscape is brimming with opportunities, and by exploring emerging markets and international stocks, you can harness the advantages of geographical diversification, potentially tapping into the exceptional growth stories and returns offered by these vibrant economies. In doing so, you can create a well-rounded and resilient portfolio that maximizes the potential for financial success.

Investing in international funds introduces an additional layer of diversification, which extends beyond the scope of stocks and bonds – it's currency diversification. This unique facet of international investing can be a double-edged sword, with its impact dependent on the relative strength of currencies, such as the US dollar versus the Euro.

Consider this scenario: when the US dollar is robust and outpaces other currencies, like the Euro, your investment yields more Euros per US dollar spent. This, in turn, translates to acquiring more international stocks for each US dollar invested. However, should the US dollar subsequently weaken, the dividends earned in Euros will convert into a larger sum of US dollars. This dynamic showcases the interplay between currency exchange rates and investment returns.

While it might seem tempting to time currency fluctuations, accurately predicting currency movements is a notoriously complex endeavor. Currency hedging, a strategy designed to mitigate the effects of currency volatility, is one approach. Nonetheless, it's crucial to recognize that timing currency markets is intricate and often unpredictable.

In the grand scheme of things, the inclusion of currency diversification within your investment portfolio serves as a prudent risk-reduction strategy. It provides resilience against the impacts of currency fluctuations over the long term, fostering a more stable and robust investment portfolio.

(Source: Fidelity.com)

International stocks present an alluring prospect for investors with a keen interest in dividends. These international funds often offer enticing dividend yields. However, it's important to note that the consistency of dividend payouts in international stocks may not match the level seen in US stocks.

For instance, Emerging Market funds typically boast a yield of 2.41%, while Developed Market funds offer a yield of 2.77%. When compared to the Total US stock market with a yield of 1.75% (or the S&P 500 at 1.87%), these international dividend yields present a potentially attractive proposition for income-oriented investors.

It's worth mentioning that, much like the well-known US dividend achievers, there are also international dividend achievers. We'll delve deeper into this in a subsequent discussion.

For investors delving into international dividend opportunities, it's important to be aware of the tax implications. The Internal Revenue Service (IRS) offers mechanisms such as a foreign tax credit or an itemized deduction for taxes paid to a foreign country on foreign-source income, including stock dividends, which are subject to U.S. taxation. These provisions help investors navigate the complexities of international dividend income within the scope of US tax regulations.

(Source: www.macrotrends.net)

Looking back in history, it's evident that international stocks have demonstrated their potential to outperform US stocks over extended investment horizons. As a passive investor, one essential principle is the recognition that attempting to time the market is a challenging and uncertain endeavor. This leads to the thoughtful consideration of adding international funds to your investment portfolio, a strategic move that could potentially yield a significantly higher return on investment (ROI).

In the current financial landscape, it's notable that all-encompassing US stock market indices have reached unprecedented all-time highs. This surge in valuation has created a challenging environment for value-seeking investors, as opportunities for undervalued assets become scarcer. In contrast, international stock markets present a different picture, with considerably lower valuations. Emerging markets, for instance, exhibit a P/E (Price-to-Earnings) ratio of 14.8, while developed markets maintain a P/E ratio of 16.0.

These contrasting valuation metrics may hint at the potential for higher growth prospects in international markets in the future. This dynamic provides a unique opportunity for astute investors to identify and acquire undervalued stocks with strong growth potential. It's worth emphasizing that the US stock market, in comparison, carries a higher P/E ratio, currently standing at 22.7.

This scenario underscores the attractiveness of international stocks, not only as a means to diversify your portfolio but also as a promising avenue to discover value stocks with the potential for substantial future growth. While the US market continues to break records, international markets offer an appealing alternative for value-oriented investors seeking more favorable investment opportunities.

(Source: time.com (2016))

When considering investments in international funds, it's crucial to recognize that they often come with a higher price tag compared to US funds. This cost differential is an important factor to weigh when making investment decisions. For developed market funds, the Lipper average expense ratio stands at 1.336%, and for emerging market funds, it's even higher at 1.502%. It's worth noting that this expense differential between developed and emerging market funds exists for clear reasons, as emerging markets typically present more complex investment landscapes and higher operating costs. 

In contrast, the Lipper average expense ratio for Total US market funds is relatively lower, at 1.12%. These expense ratios reflect the costs associated with managing these funds and administering the investments within their respective markets.

Investors should take into account these expense ratios when building their portfolios, as they can significantly impact the overall returns over time. While international funds may come at a higher cost, they can still offer valuable diversification and exposure to global markets, making them a strategic addition to your investment strategy.

In summary, I firmly advocate for the inclusion of international stocks within our investment portfolios. They play a pivotal role in diversifying our holdings, which can contribute to a more resilient and balanced investment strategy. The recommended allocation for international stocks typically falls within the range of 30-50% of the total portfolio. By embracing this allocation, investors can harness the potential for broader diversification and exposure to global market opportunities, ultimately enhancing the robustness of their overall investment approach.

As per insights from Vanguard, maintaining an allocation of approximately 30% of your equity holdings in non-U.S. stocks has historically delivered a substantial portion of the potential diversification benefits. In my own portfolio, I've implemented this guidance, comprising 30.63% in international funds, with a breakdown of 24.56% in developed markets and 6.07% in emerging markets. However, it's important to recognize that the optimal allocation can be influenced by your individual risk tolerance and investment objectives.

Furthermore, you might contemplate the notion of relying solely on the S&P 500 for international exposure, bypassing the use of dedicated international funds altogether. This approach aligns with the concept of customization, tailoring your investment strategy to your specific preferences and comfort level. Ultimately, your allocation decision should be a well-informed one that reflects your unique financial goals and risk appetite.

In the upcoming Part (2) of this article, we will delve into a comprehensive exploration of the various international funds available through Vanguard.