Portfolio Design: A Modern Approach to Asset Allocation

SUMMARY—KEY FEATURES OF FOREIGN STOCKS

In the long run, foreign stocks deliver comparable returns to those of U.S. stocks. From year to year and decade to decade, however, there are wide variations in performance across regions of the world. This provides a strong argument for diversification.

It has long been recognized that the relatively low correlation between foreign and U.S. stocks provides a portfolio diversification benefit. That correlation, however, has risen sharply since 1998. Most observers believe that the rising correlation is due to the increased integration of the world economy. There should be some doubts about this explanation if only because the rise in correlation occurred abruptly beginning in 1998 rather than in a continuous process over last 20 years as integration occurred.

Currency movements influence stocks, particularly in the short run. The most dramatic example is found during the first and second terms of the Reagan administration when the dollar first soared, then fell back to earth. More recently, the dollar rose sharply against the Euro in the first three years of the latter’s life only to fall back sharply since then. There is little evidence, however, that short-term currency movements can be accurately forecasted on a consistent basis.

Investors like to find shortcuts to investing in stocks listed on foreign exchanges. Buying ADRs instead of foreign stocks provides an effective way to diversify internationally because arbitrage keeps returns ...