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Is it time to invest more internationally?

Most investors I meet with do not have sufficient exposure to international stocks and bonds. I believe this is a mistake. You can reduce your overall risk and increase your return potential by having the right allocation to international investments. Of course this allocation is different for everyone and depends on many variables such as your risk tolerance level, goals and time horizon.

During the 1990s, the U.S. stock market clearly outperformed international stocks. But that was not always the case — international markets outperformed U.S. stocks during the 1980s. A study of l0-year annualized returns for the Standard & Poor’s 500 (S&P 500) and the Europe, Australasia, and Far East (EAFE) index from 1970 to 2000 found that the EAFE outperformed the S&P 500 in 15 of those 21 periods.

With the U.S. markets having dominated in the 1990s, are international investments set to start outperforming in the coming years? While no one knows for sure, there may now be opportunities to find investments in other parts of the world that are more attractively priced than those in the U.S. In addition the weakening of the dollar will give a boost to foreign investment returns.

One of the primary advantages for international investing is to reduce the volatility in a portfolio through diversification. The theory is that when the U.S. stock market is declining, investments in other parts of the world may counter that trend. Recently, however, it appears that during periods of crisis, stock markets throughout the world have moved in the same general direction. While that reduces the diversification benefits, it remains to be seen whether the correlation stays at these higher levels or comes down to more historical levels.

Also keep in mind that correlations relate to foreign stock markets overall. The correlation between the U.S. stock market and specific foreign stock markets can be significantly different. For instance, historical correlations between the U.S. and Canadian stock markets are very high while the U.S. and Japanese correlation is lower. Emerging markets typically have a very low correlation with the U.S. stock market.

I have found that we get the best effects of international diversification from using actively managed value-oriented mutual funds that invest in smaller overseas companies. The smaller international companies tend to perform more in line with the local economy whereas the larger international companies reflect the global environment more.

When considering international investing, make sure you understand the significant role of currency fluctuations. Your return from an international investment is comprised of two components: the investment’s return in local dollars and the impact of any currency fluctuations. Part of the reason U.S. investments dominated in the 1990s was due to the strong U.S. dollar. Now, the U.S. dollar is starting to show some weakness against other currencies, which could bolster the returns of foreign investments.

During 2002, the U.S. dollar dropped more than 10 percent against the Euro — which has softened the blow to international returns. When choosing which mutual funds to invest in overseas be sure you understand if they hedge against the currency risk. Some international mutual funds that did well in the late-1990s did so primarily due to hedging out currency risk. This worked well when the dollar was getting stronger, but you will not benefit from a declining dollar environment with this type of mutual fund.

The U.S. stock market now represents only slightly more than half of the total market capitalization of the world. Limiting yourself to U.S. stock investments means eliminating nearly half of the world’s investments from consideration. In a number of industries, the world’s leading companies are not U.S.-based companies. International investing is increasingly moving from a methodology of selecting regions of the world to invest in to selecting stocks of leading companies, no matter where they are based.

For all these reasons, now may be a good time to take another look at international investing. Keep in mind, however, that international investments may not be suitable for everyone. In addition to the risks associated with domestic investing, foreign investing has unique risks, such as currency fluctuations, political and social changes, and greater share price volatility.

Raymond D. Mignone is a fee-only Certified Financial Planner & Registered Investment Advisor specializing in retirement planning and investment management; he can be reached in Little Neck at 718-229-2514 or at www.raymignone.com.

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