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I've decided to make a dedicated thread to this topic. We've already had significant discussions regarding retirement investing in the "Our financial system is crumbling this week." thread which is worth checking out. Most of the investing discussions start here.

As an FYI - this is my personal investment strategy:

I'm starting to see more and more of this chatter:

The Atlantic: Are Index Funds evil?









Although I think there is a logical conclusion where index funds distort the markets, most mainstream economists don't think we're close to a significant problem. I also find the concerns in the article to be unconvincing.

It's also worth noting, there are a lot of powerful people who don't like index funds because they cut in to their bottom line.

For those who wonder, if I have X amount of dollars when I retire, what can I safely withdraw each year? A guy named Bill Bengen looked in to this and he determined a 4% withdrawal rate (later modified to 4.5%) adjusted for inflation is very safe over a 30 year period. He recently did a pretty good AMA, where he explains the concept:



That % doesn't include social security. Also, this is based on retiring with a 50/50 bond to equity ratio. Obviously no one knows what the future will bring, but I like this concept to help with planning.

9 1/2 years ago Warren Buffet made a famous 1 million dollar bet with a hedge fund manager that pitted 10 years of returns of hedge funds against a simple S&P 500 index fund. You can listen to a fairly entertaining NPR podcast about the bet here.

Well, Buffet is winning bigly:



The hedge fund guy, Ted Seides, just wrote an article conceding with completely unconvincing rationalizations.

First off, I realize no one cares about this thread and it's basically a personal blog. Given no one reads any of this, my plan in the near future is to start posting erotic fan fiction about the moderators. Their selfless dedication to making GRB a cool place to hang out heightens my desire to defile them.

Anyway, I digress. Today I want to post some random thoughts about international equities. This post is for anyone who is skittish about investing international or would like to understand the benefits of international equities investing better.


The Case for International Equities

It's totally understandable that someone might be skeptical about investing internationally. In the last 40 years US index funds have performed much better than international. Here's a chart that illustrates that fact:




Domestic has routed international. However, there's several reasons why I think international equities diversification is still a very attractive option to any portfolio:


1) Japan has been a huge drag on international performance. In the late 80's Japan's stock market valuation was higher than the US. So if you purchased an international index in the late 80's and 90's you were mostly buying Japanese stock. Today Japanese stocks represent about 17% of an international index. In essence you don't have to worry as much about one country tanking the index anymore. More on Japan later.

2) In the past 5-10 years international index fees have gone down significantly. For example, Vanguard's total international has a 0.11% expense ratio which is very reasonable.

3) Portfolio diversification. Let's get back to Japan. Here's the horror story of Japan's stock market in one graph:





Japan still hasn't recovered from its high in the 80's. Now you may look at this graph and think to yourself this is why I don't want to invest international. However, I take the opposite view. There's no rule that says this type of performance can't be the US in the future. I'm not saying it's likely, but it is possible. That's why diversification is powerful/important for any portfolio. International equities gives you significant diversification if the US market tanks like Japan.

Now, some will argue "big US companies do a lot of business overseas so I'm basically diversified in international". However, a Vanguard white paper shows that the correlation isn't as high as most people imagine (figure 2). Additionally, you'll be missing out on industry weighting:




4) Another concern with international is currency fluctuation risks. However, the same Vanguard white paper demonstrates long term currency fluctuations do not materially impact equities prices and actually help with diversification (page 12).

5) I hesitate to post this last point because it's slightly a market timing thing, but here we go...

Valuations for US equities are historically high right now. It's worth noting, valuations are only a good predictive factor of market returns in the long term (10+ years) and have little correlation with returns in the short term (< 3 years). However, if you are planning to keep your money invested for a long time it doesn't hurt to be aware of valuations. For instance, take this graph:



Higher CAPE means higher valuations. CAPE for the S&P 500 is currently ~31. In non-US developed markets it is roughly 20. CAPE isn't a perfect measure, but if historical patterns hold, it is more probable that we will see higher returns in the next 10-15 years from non-US markets.


How to Add International Equities to a Portfolio

As I've posted in the past I'm a big fan of the simple 3 fund portfolio. It's how I invest. That said, even if you don't utilize a 3 fund portfolio adding international equities exposure is conceptually easy to do. My recommendation is to add 20-40% international equities to your overall equities exposure with a low cost index fund. According to Vanguard, 20% international equities gives you over 80% of full diversification benefits. 30% is 99% of full diversification benefits. 40% is almost full market weighting.

Here's how international equities weighting works in practice (I arbitrarily added 20% bonds, however your allocation might/should be different):

20% (Over 80% of full diversification benefits)

80% Equities
20% Bonds

80% Domestic Equities
20% international Equities

That means for every 100 dollars you invest it should have the following allocation:

Equities - $80 (domestic vs international allocation formula below)

.....80% Domestic Equities - $60 = 80 * .8
.....20% international Equities - $16 = 80 * .2

Bonds - $20


30% (Over 99% of full diversification benefits)

80% Equities
20% Bonds

70% Domestic Equities
30% international Equities

That means for every 100 dollars you invest it should have the following allocation:

Equities - $80 (domestic vs international allocation formula below)

.....70% Domestic Equities - $56 = 80 * .7
.....30% international Equities - $24 = 80 * .3

Bonds - $20


40% (almost full market weighting)

80% Equities
20% Bonds

60% Domestic Equities
40% international Equities

That means for every 100 dollars you invest it should have the following allocation:

Equities - $80 (domestic vs international allocation formula below)

.....60% Domestic Equities - $48 = 80 * .6
.....40% international Equities - $32 = 80 * .4

Bonds - $20


Summary

Investing in international equities is something you should consider. Anywhere from 20%-40% ratio to your overall equities portfolio can provide significant benefits.

Let me know if you have any questions.


***Michael is not a licensed financial adviser and provides investment advice for entertainment purposes only. Not available in all 50 states. Void where prohibited.***

It's a lot easier to blow your money on [expletive] that will kill you and not have to worry about this.

Erotic fan fiction is good. It ensures people don't lose their imagination.

That being said, I currently don't have any portion of my retirement account invested in international equity. As you said, diversification is key. My particular plan's expense ratios have historically been higher for international equity funds than domestic funds, and their performance hasn't been high enough to offset the higher expense ratios. I typically rebalance and/or change funds a couple times a year, so perhaps I'll shuffle some lower performing domestic funds around with international ones.

I'm pleased unscientifically selecting 25% falls in this range.

You should do a post on whether weighting up small caps makes sense.

Edit: Though given the PE data you report in this post, it makes me think it's actually an underweight. Where does one go for international CAPE data?

I hear you on the fees thing. Although, if you have access to good index funds the fee differences aren't really that big. For example, the Vanguard Total Stock Market Index Fund has a fee ratio of 0.04% and the international has 0.11%. A nearly 3x difference sounds like a lot. In reality with these low cost index funds the difference isn't huge because fees are already very low. If you invest 100K in each fund the cost difference between them is about 70 dollars a year.

For US equities? I don't think so. Although I prefer total stock market indexes (includes small cap), the performance differences between US total stock market and the S&P 500 index funds are almost immaterial.

I would keep it simple and not get too cute by adding several funds for weighting.



Here's the white paper that created that CAPE pic. See page 11. There's lots of data to dive in to. They also have this site that's interactive. I haven't played around with it too much.

It's worth noting, technically CAPE should be higher than other times because companies don't pay dividends like they used to. Regardless, US valuations are very high compared to the rest of the world.