(PUB) Investing 2016

be in U.S. stocks, and the other 47% should be in foreign stocks. And that’s exactly what you’ll get if you invest in the fund. For those who are indexing purists, this is gospel. Vanguard appears to be moving towards the efficient market thesis of matching the global markets with your own portfolio. They currently claim that a 40% allocation to non-U.S. stocks is optimal, but that’s just the latest itera- tion of the company’s advice, which has steadily increased recommended allocations from 10% to 20% to 30% in the past. Should I Stay or Should I Go? So what’s the answer? Do the big U.S. multinational firms owned by domestic stock fund managers provide enough of a foreign flavor for your portfolio given their global reach, as Jack Bogle would have you believe? Alternatively, should we instead allo- cate 50% of our portfolios to non-U.S. companies? Or is it sufficient for a U.S. investor to take the middle ground and allocate just 10% or 20% of their stock portfolio to foreign shares? Unfortunately, there is no answer that will satisfy every investor. For my money, I absolutely want some expo- sure to overseas stocks, but I don’t go as far as Vanguard’s 40%. Using the Model Portfolios as a guide, our foreign stock exposure ranges from 11% to 17% when I tally up the allocations of all the funds in those Models . So why do I want foreign stocks? First, it is a great big world out there. Yes, there are over 3,600 companies in Total Stock Market Index ’s portfolio. But even if I own every single company in the U.S., there are over 6,000 com- panies in Total International Stock Index ’s portfolio that I wouldn’t have any exposure to. Companies based in foreign lands with local, feet-on-the- ground expertise and experience in their own markets often have a distinct advantage over multinationals, particu- larly when it comes to more localized businesses. Yes, an oil company or a major drug producer may be able to sell its wares as easily overseas as it does in the U.S.,

U.S. and ForeignMarket Correlations Have Fallen

Cyclical Dollar

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Rising line = Dollar is appreciating

(against a basket of 26 currencies)

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returns in foreign markets. A falling dollar makes shares in foreign curren- cies worth more; a rising dollar makes them worth less. The second graph above shows the performance of the U.S. dollar against a blend of currencies from 26 of our trading partners. As you can see, there are stretches like the late 1990s and the past five years when the dollar has appreciated greatly against many other currencies. But there have also been periods when the dollar has fallen, and this has ultimately boosted the returns of foreign holdings. Correctly predicting the swings of in the currency markets is just as dif- ficult as predicting the stock or bond markets—it’s not a game I want to play. Consider that famed investor George Soros, who made $1 billion in a trade against the British pound in 1992, was long the pound going into the Brexit vote, a losing bet. Oops! The pound fell 11.1% to a 30-year low against the dol- lar in the two days following the vote to leave the E.U. That’s currency risk for you. Now, what about political risk? When invest- ing in a foreign stock fund, you are not only making a wager on the prospects of a set of companies, you are also making an investment in the political and economic stability of the countries and markets those stocks are traded in. Until recently, this risk was the domain of emerging market economies. Unsustainable levels of debt, threats of default and currency devaluation, rising interest rates, bank runs, failed elections—these were supposed to >

but local cement makers, retailers and service providers probably have a good leg up on their foreign competitors. Do you like Google? Google doesn’t have anywhere near the reach in China of Baidu, which happens to be the third-largest holding in International Growth ’s portfolio. Owning foreign stocks also provides exposure to different economic and market cycles, which helps to diversify your portfolio. While there are times when correlations between markets have been high, meaning the diversi- fication benefit was low, that hasn’t always been the case. Correlation is a measure of how syn- chronized two markets are. If the U.S. market and international markets were in complete synchronicity, they would have a correlation of 1.00, which implies they move 100% in lockstep. Over the past decade, the correlation between U.S. and foreign markets have moved closer to 100% as the global economy has become more intertwined. Yet, as you can see in the first graph above, they’ve never been perfectly correlated, and the recent trend has seen their syn- chronicity lower than in years past. I would be remiss if I didn’t discuss two additional areas of risk that must be weighed—currency and political risk. Unlike owning U.S. funds or ETFs, when you buy a fund or ETF investing in overseas markets, you own stocks that are valued in their local currency, be it the Japanese yen, the euro, or the Brazilian real. The movement of the U.S. dollar against these curren- cies can enhance or detract from your

The Independent Adviser for Vanguard Investors • July 2016 • 13

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