Lots of Room to Grow

By Daniel Kadlec

We Americans tend to place ourselves at the center of the universe. So Wall Street's latest theory on foreign stocks--basically that we don't need them--may be the easiest pitch since Bogie wooed Bacall. The come-on plays to our ego and promises to simplify investing. The trouble is that like so many theories that come and go, it's based on what has been happening lately--which is anything but typical.

So don't shun foreign stocks. Instead, learn the smartest new thinking about how to play them. Modest exposure to foreign stocks--15% to 20% of a stock portfolio--can still help investors reduce risk while boosting returns. The key is owning the right foreign stocks. And these days that usually means focusing on small companies, which are best bought through a mutual fund. Why is smaller better? As the economy has gone global, large companies increasingly sell their stuff everywhere. Their fortunes (and stocks) move together. So Royal Dutch Shell doesn't provide much diversification if you already own Chevron.

Although small companies are not immune to the lockstep nature of the global economy (many sell to multinationals), in general they remain far more leveraged to their home markets. The stock of, say, a retailer in India is less likely to be dragged down by a U.S. recession. Yet that same recession would clearly hurt a big Indian technology exporter.

Until recently, few pros would even debate the value of moderate exposure to foreign markets. But a backlash has surfaced. Merrill Lynch, for example, now advises clients that foreign holdings should make up only about 5% of their stock portfolios. More important, the firm contends, is diversification by industry. That has long been a prudent part of portfolio management. But now some say it's the only part you need. If you are in the big global industries--technology, media, consumer cyclicals, health care, energy--you have all the diversification you need, even if all the companies are based in the U.S.

The domestic-only mantra springs mainly from three sources: torrid appreciation of U.S. stocks in the '90s, a measurably closer correlation between U.S. and international stocks on the whole, and an important study last year showing that correlations are tightest in bear markets--meaning that diversification doesn't insulate you much just when you need it most. So why bother?

Here's why. Investors looking at the staggering success of the Japanese market in the decade before its 1989 pinnacle may have seen no reason to put money anywhere else. And they would have lost more than half their money over the next 10 years. Even if you believe such losses could never happen in the U.S., this points up how quickly hot markets can cool while others ignite.

During their glorious run from 1984 to 1999, not once did U.S. stocks place first among 11 major markets, including France, Germany, Singapore, the Netherlands, Britain, Japan, Hong Kong, Australia, Switzerland and Canada. On a yearly basis, U.S. stocks finished in the bottom half more than half the time, according to Morgan Stanley Capital International. While U.S. stocks did well, you would have had less volatility and higher returns by owning foreign stocks too.

Over the past 15 years, the correlation of U.S. stocks to major international markets has been .51, but it shot to .78 over just the past three years, according to J.P. Morgan Private Client Group. (A reading of 0 means that two markets are as likely to go in opposite directions as they are to go in the same direction; 1 means that two markets always go the same way.) Kirt Butler, professor of finance at Michigan State University, and Domingo Castelo Joaquin, professor of finance at Illinois State University, found in a study that correlations go even higher in down markets. Think of the 1987 stock-market crash. No major market escaped the damage.

Still, I would argue that a little cushion is better than no cushion. And small-cap foreign stocks give you the most protection. Over the past three years, their correlation with U.S. stocks has been just .57. And remember that market relationships constantly shift. High correlations don't have to stay that way. Now that the global tech bubble has burst, different stock groups may emerge as leaders in different regions. Which makes now a fine time to buy a good foreign small-cap fund, such as T. Rowe Price International Discovery or Wanger International Small Cap. On Wall Street, once a theory gets popular, it's time to try another.

See time.com/global for more on foreign small caps. E-mail Dan at time.com