April 11, 2012

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How Much Foreign Is too Much Foreign?

By David B. Loeper, CIMA®, CIMC®

"He looks at foreign affairs through the wrong end of a municipal drain pipe."
- Sir Winston Churchill

As of the end of 2011, we now have a forty-one year history to examine how foreign stocks, as measured by the EAFE Index, performed relative to US Domestic Equities. EAFE produced a forty-one year compound return of 10.07%, US Domestic Equities returned 10.13% and the less diversified S&P500 produced a 9.92% compound return.

Considering that the long term returns are essentially identical with large samples of random outcomes among thousands of stocks (as should be expected), how much of your stock allocation should be committed to foreign stocks?

There are various schools of thought on this topic. Some argue that it should be based on global market capitalization, of which US Stocks represent about 30%. This would argue that 70% of your stock allocation should be committed to foreign stocks. Others might use the historical data to find the "optimal" compound return in blending foreign and domestic stocks and determine that somewhere around 40-60% in foreign is appropriate.

Because foreign stocks have significantly higher volatility (22.88% standard deviation for foreign versus 18.21% for domestic) this decision should not be taken lightly. One has to remember that the main difference between foreign and domestic stocks is that foreign stocks introduce currency risk. In determining the optimal foreign allocation, we Defy the Common™ by taking a different approach than much of the conventional wisdom.

Since there should be no expectation for any higher return for foreign versus domestic stocks (where a stock is traded or the country in which it is headquartered should not determine its expected return, and the last forty-one years provide some anecdotal evidence to this premise), in theory the only benefit that one should obtain from an allocation to foreign stocks is diversification...lower volatility...less uncertainty. Designing your allocation to foreign stocks from the perspective of what is optimal to reduce uncertainty from a probabilistic view results in a significantly different answer than current conventional wisdom. Getting to this answer also takes a lot more effort than simply calculating misleading average returns, standard deviations or Sharpe ratios.

Since our value is focused on measuring uncertainty by using probabilities to provide advice to our clients that gives them confidence in exceeding the goals they value, we have to look much deeper into the numbers. Probabilistic uncertainty (the range of potential outcomes) is the extent and frequency of deviations in the observations that cause us to use statistics that are often ignored in classic MPT applications.

For example, the median return is generally ignored in most applications of MPT. But, it gives us meaningful information from the basis of probabilistic uncertainty; because it tells us the point in the range of uncertainty where half the observations were higher and half were lower. Average and compound returns are easily skewed by outlier observations and ignore this extent and frequency effect.

Over the last forty-one years, the median return for domestic Stocks was 16.09% versus 11.63% for EAFE, even though the compound return for domestic stocks was only 0.06% higher. Remember, half of the observed returns would be higher and lower than these numbers, which is probabilistically useful information.

By using a "boot strapping" type of approach in rolling three year periods, we can observe there were three year periods when foreign stocks underperformed domestic stocks by more than 22% annualized. That's a lot. Imagine trying to explain that to a client you acquired at the start of that three year period when half of their equity exposure underperformed by more than 22% annualized if you had 50% foreign exposure.

In 56.41% of the historical rolling three year observations, foreign stocks underperformed domestic stocks. That is a frequency observation completely lost in observing only annual returns. We can also observe that the median three year relative return is slightly positive to zero with up to 15% foreign allocation, but consistently becomes negative starting at a 20% allocation to foreign and consistently becomes more negative with greater foreign exposure.

The diversification benefit we are seeking (depending on which statistics and time frames you are using) consistently show maximum reduction in volatility relative to an all domestic equity portfolio with somewhere between 10-20% allocations to foreign. Volatility is uncertainty, and it is clear that at least historically, once you exceed a 20% foreign allocation, volatility increases. Increasing uncertainty defeats the very premise for using foreign equities in portfolios.

Finally, with the Wealthcare Way™ we control what is controllable, and it is no secret that foreign stocks are far more expensive. Consider that even Vanguard's VEU (World Equities ex-US) costs three times as much as VTI (Total Domestic Equities).

So, with optimal reduction in uncertainty falling at somewhere between 10-20% in foreign equity exposure, we choose to allocate 15% of our equity exposure to foreign stocks. The forty-one year compound return of 15% foreign equity exposure is 0.12% less than an "optimal return" manager's choice of a 50/50% allocation to foreign and domestic. But, the 15% foreign exposure has 0.76% less standard deviation, its lowest three year compound return is 0.89% higher, its median one year return is 0.51% higher, it outperformed in 51.3% of the historical three year periods, and the costs (which are the only thing in all of this that is certain) are 35% less.

In our view of focusing on uncertainty and its impact on confidence in exceeding goals that clients personally value, having any more than 20% of the equity allocation committed to foreign stocks simply adds uncompensated additional risk.

That is just one more reason why Wealthcare Capital Management® continues to Defy the Common™ and innovate unique solutions that are Powering the Future of Financial Advising®.

Contact us to learn more about our foreign equity risk research.


Join Our Revolution! Visit us at www.WealthcareCapital.com or call us at 877-883-7526

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A popular industry speaker, inventor and writer, DAVID B. LOEPER is the CEO and founder of Wealthcare Capital Management, Inc. in Richmond, VA. He is author of the top selling book Stop the 401(k) Rip-off!, three other books released in 2009 – 2011 by John Wiley & Sons (Stop the Retirement Rip-off, Stop the Investing Rip-off and The Four Pillars of Retirement Plans) and numerous whitepapers. He is the inventor behind several US and International patents, has appeared on CNN, CNBC, Fox Business and Bloomberg TV, served on the Investment Advisory Committee of the $30 billion Virginia Retirement System, and was chairman of the Advisory Council for the Investment Management Consultants Association (IMCA). Before founding Financeware in 1999 (the predecessor to Wealthcare Capital Management®) he was Managing Director of Strategic Planning for Wheat First Union. He earned the CIMA® designation (Certified Investment Management Analyst®) from Wharton Business School in 1990 in conjunction with IMCA.

IMPORTANT DISCLOSURES: Examples and concepts used in this educational email are intended for illustrative, educational purposes only. Nothing in this email should be construed as investment advice regarding any particular investments for any particular individual circumstance and you should consult with your own financial advisor regarding your personal situation. There is no representation or guarantee of specific results, explicit or implied. In addition, the information based on historical time periods cited or other information generated by Wealthcare Capital Management® do not reflect our actual investment results and are not guarantees of future results. All returns cited are based on gross asset class performance before advisory, transaction or other fees. Illustrative data used in this educational email provided by sources believed to be reliable but not verified independently by Wealthcare Capital Management®.

Wealthcare Capital Management, Inc. is a Registered Investment Adviser and its SEC Form ADV Part 2A is available through the internet.

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