As an investor, I often face the challenge of deciding how much to allocate to domestic versus foreign stocks. The right mix can enhance returns, reduce risk, and provide exposure to global growth. In this article, I explore the key considerations, mathematical models, and practical strategies for optimizing foreign and domestic stock allocations.
Table of Contents
Why Asset Allocation Between Foreign and Domestic Stocks Matters
Asset allocation determines portfolio performance more than individual stock selection. Diversifying across geographies helps mitigate country-specific risks—such as political instability, currency fluctuations, and economic downturns—while capturing growth in emerging and developed markets.
Historically, US stocks have outperformed foreign equities over long periods. However, past performance does not guarantee future results. Non-US markets sometimes deliver higher returns, making a strong case for international diversification.
The Mathematical Case for Diversification
Modern Portfolio Theory (MPT) suggests that combining assets with low correlation reduces overall portfolio risk. The expected return E(R_p) of a two-asset portfolio (domestic and foreign stocks) is:
E(R_p) = w_d \cdot E(R_d) + w_f \cdot E(R_f)Where:
- w_d = weight of domestic stocks
- w_f = weight of foreign stocks
- E(R_d) = expected return of domestic stocks
- E(R_f) = expected return of foreign stocks
The portfolio variance \sigma_p^2 is:
\sigma_p^2 = w_d^2 \sigma_d^2 + w_f^2 \sigma_f^2 + 2w_d w_f \sigma_d \sigma_f \rho_{d,f}Where:
- \sigma_d = standard deviation of domestic returns
- \sigma_f = standard deviation of foreign returns
- \rho_{d,f} = correlation between domestic and foreign returns
A lower correlation means better diversification benefits. Historically, the correlation between US and international stocks has been around 0.7 to 0.8, suggesting moderate diversification benefits.
Historical Performance: US vs. Foreign Stocks
The US market has dominated since the 2008 financial crisis, but foreign stocks have had periods of outperformance. Below is a comparison of annualized returns (1970-2023):
| Asset Class | Annualized Return | Volatility |
|---|---|---|
| US Stocks (S&P 500) | 10.2% | 15.4% |
| Developed Markets (MSCI EAFE) | 8.1% | 17.2% |
| Emerging Markets (MSCI EM) | 9.5% | 22.6% |
While US stocks delivered higher returns with lower volatility, emerging markets offered higher growth potential—albeit with more risk.
Key Factors Influencing Allocation Decisions
1. Home Bias and Behavioral Factors
Many US investors overweight domestic stocks due to familiarity, currency concerns, and tax implications. However, excessive home bias can lead to missed opportunities.
2. Currency Risk
Foreign investments introduce exchange rate fluctuations. A weakening dollar boosts foreign returns when converted back to USD, while a strengthening dollar reduces them.
3. Valuation Differences
Foreign markets often trade at lower price-to-earnings (P/E) ratios than US stocks, suggesting potential undervaluation.
4. Economic Growth Trends
Emerging markets may grow faster than developed ones, but political and regulatory risks can offset gains.
Strategic vs. Tactical Asset Allocation
- Strategic Allocation sets a long-term baseline (e.g., 60% US, 40% foreign).
- Tactical Allocation adjusts based on market conditions (e.g., increasing foreign exposure when valuations are attractive).
A common starting point is the global market cap weight. As of 2023, US stocks comprised about 60% of the global equity market, with foreign stocks making up the remaining 40%.
Practical Allocation Strategies
1. Market-Cap Weighted Approach
Mimics global indices like the MSCI All Country World Index (ACWI).
2. Fixed Ratio (e.g., 70/30 Split)
Maintains a set proportion regardless of market movements.
3. Dynamic Rebalancing
Adjusts allocations based on relative performance to maintain risk levels.
Example: Calculating Optimal Allocation
Suppose:
- Expected US return (E(R_d)) = 8%
- Expected foreign return (E(R_f)) = 10%
- US volatility (\sigma_d) = 15%
- Foreign volatility (\sigma_f) = 20%
- Correlation (\rho_{d,f}) = 0.7
Using the efficient frontier formula, we can find the optimal mix that minimizes risk for a given return.
Risks of Over-Allocating to Foreign Stocks
- Higher transaction costs
- Political instability
- Liquidity constraints in emerging markets
Final Thoughts
A well-balanced portfolio includes both US and foreign equities. The exact allocation depends on risk tolerance, investment horizon, and market outlook. I recommend a baseline of 60% US and 40% foreign, with periodic rebalancing to maintain desired exposure.
