How to Create an International Investing Strategy

When Americans check market updates online or on TV, they typically see data for the Dow Jones industrial average, the Standard & Poor's 500 index and the Nasdaq Composite. Although the data reflect performance of three separate indexes, Americans are really getting information about one asset class: large-cap domestic stocks.

Not only does that leave out fixed income and domestic stocks with a smaller market capitalization, but it fails to include the entire world of investments beyond U.S. shores. According to research from the Vanguard Group, approximately 49 percent of the global equity market resides in the U.S.

Christopher Philips, senior investment analyst with Vanguard Investment Strategy Group, authored two 2014 white papers on international diversification. One paper focused on equities, and the other on fixed income. Both papers identified benefits to U.S. investors who allocate some portion of their portfolios overseas.

Philips points out that investors throughout the world have what's called a "home bias," meaning they gravitate toward domestic investments. That's true for both stock and bond investing.

"There is a pretty significant portion of the world that someone who is 100 percent invested in the U.S. is missing out on," Philips says. "That's a great starting point to think about whether they should be investing internationally, and if so, how much?"

Jonathan Satovsky, founder of Satovsky Asset Management in New York, says the amount an investor should allocate internationally depends on factors such as risk tolerance and open-mindedness about potential economic growth throughout the globe. To illustrate that potential, Satovsky cites a 2012 white paper from Grandeur Peak Global Advisors, which notes that between 2001 and 2011, the number of overseas initial public offerings outpaced the number of U.S. IPOs by more than 11 to 1.

However, Satovsky says he believes investors need to be comfortable with their non-U.S. allocations and keep their risk levels tolerable. He terms that the "sleep at night" factor, which prevents investors from constantly worrying about portfolio performance.

"There's a huge world out there and a lot of opportunity, so it's naive to think the U.S. has all the answers. There are talented, smart, creative people around the world. It's just a question of whether their laws and regulations allow them to be as entrepreneurial as a Facebook or Google or Apple, and allow you, outside the region, to participate," he says.

For investors who are not comfortable venturing outside the U.S. for their portfolio holdings, Satovsky says it may make sense to maintain a domestic focus. "If a person only wants to invest in things they know and understand, like the S&P, the truth is, they will likely be more successful because they understand it and will stick with it," he says.

Over the past couple of years, with U.S. markets being dominant, investors with a domestic focus had a lot to celebrate. No region maintains a permanent lock on market leadership, however. Europe, Japan and emerging markets have all outpaced other markets at some point. They have also underperformed. For that reason, many asset managers advise against trying to pick winners when investing internationally.

Ryan Issakainen, senior vice president and exchange-traded fund strategist for First Trust Advisors, headquartered in Wheaton, Illinois, says many U.S. investors can benefit from diversified exposure to developed and emerging market stocks and bonds. First Trust offers a large number of ETFs tracking non-U.S. indexes.

Many of First Trust's country-specific funds are popular with professional asset managers who have a specific investment thesis regarding a particular country or region, he says. For retail investors who simply don't have the time or resources to thoroughly research global markets, broad overseas diversification is a simple way to allocate.

Issakainen says a home-country bias serves investors well if their home country is outperforming other markets, as the U.S. has done recently. It becomes problematic when an investor's home country begins to lag. Issakainen adds that diversification doesn't only mean buying large, well-known companies that happen to be based overseas. "If you are looking at the medium-sized companies that have more of their revenue produced in local markets, you get those diversification benefits," he says.

For nearly all U.S. investors, that means using exchange-traded funds or mutual funds rather than trying to pick foreign-based single stocks that are not even listed on domestic exchanges.

Jeff Teach, president of Teach Wealth Management in Palm City, Florida, uses mutual funds from Dimensional Fund Advisors to achieve international diversification in client portfolios. Rather than trying to time various markets or make bets on particular regions, he prefers to keep clients fully diversified at all times. The specific percentage of international investments investors should allocate in their portfolios depends on their risk tolerance and investing objectives.

Teach cautions against watching the financial news shows, which tend to emphasize day-to-day market movements in the U.S. rather than long-term trends or global diversification strategies. "We try to keep people's emotions in check because investor behavior can be one of the worst things out there," he says, referring to the propensity of many retail investors to either panic during market rough patches or chase a previously hot asset class after it has already peaked.

Teach offers coaching classes to investors, explaining concepts such as international diversification. One issue for U.S. investors is an expectation that their portfolios will track the S&P 500. With proper diversification, investors may see lower overall returns during years in which the S&P 500 index leads other indexes. However, the flip side is that they may enjoy better returns in years when the S&P 500 index lags.

"We educate the client that we are looking at the long haul -- 20 years and maybe even longer," he says. The philosophy of using globally diversified portfolio, invested for the long term, is based on research conducted by Nobel Prize-winning economist Eugene Fama, a University of Chicago professor who is also a director and consultant at Dimensional Funds. Over time, according to Fama's research, a diversified portfolio will outperform a strategy of trying to pick stocks or time the market.

Vanguard founder John Bogle holds a similar philosophy of long-term, globally diversified index investing. Vanguard's Philips advises against market timing for many of the same reasons as Teach, and says it's incumbent upon the financial services industry to educate investors on the benefits of diversifying internationally for the long haul.

"It's a behavioral thing and an emotional thing, and it's right there, every day, in front of us," he says. "In the investment industry, we have to figure out ways of articulating the benefits of broader, international exposure for the wider good of investors' overall portfolios."