What is the correct U.S. versus international equity allocation for a portfolio? In this edition of Buckingham Weekly Perspectives, Chief Investment Officer Kevin Grogan shares the principles for determining the correct equity allocation split, the cyclical nature of these investments, current valuations and the long-term forecast.
Kevin Grogan: In today’s video I’m going to answer a question we received from one of our viewers, which is what is the right U.S. versus international equity allocation for my portfolio? I’d say this is a question that has come up over and over again. I’d say over the past couple of years and honestly for my entire career really at Buckingham, it is a very very common question that comes in from investors, advisors and clients.
#1: The allocation process is cyclical.
Kevin Grogan: And so, the first thing I’ll mention is that it is kind of funny how these things go in cycles. I can remember back in the early 2010s when investors were looking backwards at the period from 2000 to 2009 and looking at the amazing run the international stocks had over that stretch of time relative to the U.S., and the tenor of the questions I and others were getting at that point in time or why do we have such a large U.S. allocation. And it’s just kind of human nature to look back at whatever did best over the recent period and want to have a greater allocation into that area of the market or into that asset class. Well now of course we’ve seen from say 2010 through 2020, we’ve seen a long stretch of time where the U.S. outperformed international stocks by a pretty wide margin over that stretch of time and so a kind of the cycle then completed itself where people started asking why do I have an international allocation looking back over the last 10 or 12 years when I can see the U.S. has dramatically outperformed international over this most recent five-to-ten-year period of time.
#2: Principles of successful investing.
Kevin Grogan: And so, the first bedrock principle I’ll come back to over the course of the video today, is that you want to have a diversified portfolio and that is kind of principle one in successful investing is diversification is your friend and this is no exception to that principle. And so, where you might start is thinking about the way the world allocates capital and if you look at global stock markets, the U.S. presents about 55ish% of the way the world allocates capital in the stock market so that could be thought of as a starting point for what the right allocation is. Although you could certainly make arguments for why a U.S. based investor might want more allocated to the U.S. than the way the world allocates capital because number one, it’s less expensive to invest in the U.S. Second, the U.S. is just more familiar to a U.S. based investor and third keeping in mind that international equities get you exposure to foreign currencies. And of course, most U.S. based investors expenses are in U.S. dollars. So those would be arguments why you might want a bit of a tilt or an overweight to U.S. stocks relative to the way the world allocates capital, but the important principle again is you want to own both because you want to have a diversified portfolio.
#3: Where are higher returns expected?
Kevin Grogan: A related question that comes up on this topic is where do you expect the higher returns to be from here? And so, the way we would answer that question is by looking at what’s called valuations or looking at the price-to-earnings ratios of U.S. companies versus non- U.S. companies. So, if you looked at a U.S. index right now, the price earnings ratio for that would be about 19, meaning you’re paying $19 for every $1 of earnings from a U.S. based company. If you were to look at international companies that price-to-earnings ratio would be closer to $13 mean you’re paying a lot less for a dollar of earnings from an international company than you are from a U.S. company. The academic evidence would say that means you have higher expected returns internationally, than you do here in the U.S. and keeping in mind, these are long-term expected returns say over the next 10 years. It’s not a prediction about what will happen over the next quarter or a year or anything like that, but we would say over kind of a planning horizon. You should expect international stocks to do better than U.S. stocks, just due to the differences in valuation. So, circling back to the question at the top is what’s the right U.S. versus international allocation? Unfortunately, I don’t think there is kind of one right answer, but I do think there are some guiding principles to keep in mind, which is I think it’s important to have at least 20% of your stock portfolio invested in international stock. So, I think that is at least a meaningful amount of international diversification. I think getting closer to say a 60/40 split would be closer to optimal. But again, there’s no one right answer here except to say that it’s important to have a meaningful amount invested internationally because again going back to those first principles of wanting to have a diversified portfolio and not having all of your eggs in one basket because you don’t know which market will wind up doing the best from here. If you do have any questions on anything I’ve covered today, please don’t hesitate to reach out to your advisor or click the link in the description below.
Kevin Grogan, CFA, CFP®
Guided by academic research, Kevin Grogan, Chief Investment Officer, oversees our overall strategy and helps clients and advisors alike distill complex investing topics.