How Much Foreign is Too Much Foreign?

The topic for this issue of OUR PROCESS came about from two current events; first, what is happening in Turkey and the possible ramifications on other Nations and second, from a book Rick just completed on China.

Unlike Venezuela, what is happening in the country of Turkey matters much more not only because they are a member of NATO, but also because their economy affects many more nations than the limited regional issue caused by Venezuela’s problems. According to my recent Global Report received from Kiplinger, Turkey’s woes are severe, and it is highly likely that they will default on their sovereign debt. Lenders most exposed include Spain, France and the UK. Secondarily, Kiplinger reports that there are other countries that share the same problems as Turkey and could be the next to fall such as Argentina, Indonesia, and South Africa.

Rick recently finished reading “The Hundred-Year Marathon” by Michael Pillsbury discussing China’s strategy to replace the USA as the world’s only global superpower. The short version is that in China’s view, the United States is the #1 enemy. According to China, beginning from President John Tyler to the present, the United States remains singularly focused on exterminating China. Delusional- yes, but this is the prevailing thought among the communist rulers in power. As such, they have implemented a long term (100 years from 1949 to 2049) strategy to defeat us. They refer to it as the 100-year marathon. According to Mr. Pillsbury who has been to China several dozen times and has been at the forefront of Sino-American policy since Kissinger was Secretary of State during the Nixon administration, the momentum may have shifted in favor of China and that unless the US begins to recognize China as an adversary, we will witness many changes in the years to come.

To be certain, these changes will have impact on the financial markets as the author claims any thought that China is interested in advancing the ideals of a free market system is sorely misplaced. Perhaps equally as disturbing was the author’s citation of China’s gross disregard for the stewardship of the environment and the expectation that China will in essence “import” its behavior to the US once we lose superiority. Apparently, the toxic pollution that China freely pours out on its land, rivers, air and people is appalling. It was an interesting read to say the least with nearly 1/3 of the book comprised of documentation to back up the claims. Ultimately, time will tell whether Mr. Pillsbury’s warnings will come to fruition or not.

These two events brought to mind our portfolio strategy as it relates to foreign countries. Because foreign stocks have significantly higher volatility compared to domestic stocks, this decision should not be taken lightly. One must remember that with foreign stocks you introduce the added variable of currency risk. Nevertheless, from a portfolio management perspective, to a large extent stocks are stocks. In other words, where a stock is traded or where the company headquarters is located should not be a factor in measuring returns. So, the only real reason to identify some companies as domestic and others as foreign is for diversification i.e. the attempt to reduce volatility and uncertainty.

Many money managers feel that equity exposure in a portfolio should match the capitalization of the world markets. Based on that logic, 60% of one’s stock positions would be outside the US. Others believe that a 50/50 allocation is recommended. Rather than base our management policy on opinion, we prefer to rely on research & data. The median three-year relative return between a mixed allocation of foreign and domestic compared to an all domestic portfolio 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. Volatility is uncertainty, and it is clear that at least historically, once you exceed a 20% foreign allocation, volatility increases which defeats the very premise for using foreign equities in our portfolios in the first place.

Furthermore, we strongly employ a philosophy of controlling what is controllable, and it is no secret that foreign stocks are more expensive. This fact alone lends to a strong bias against the use of too much foreign stocks in a portfolio. 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. Back testing this allocation reveals that the compound return of 15% foreign equity exposure is only 0.12% less than a 50/50% allocation to foreign and domestic. But, the 15% foreign exposure has a lower standard deviation and costs (which is the only thing in all of this that is certain) significantly 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.

By limiting our foreign stock exposure to 15% of our total stock allocation, we - by default - limit our risk to events overseas. A review of our current foreign positions further reveals that only 23.9% of the FTSE All-World exUS index is in the countries mentioned by our recent Kiplinger report. So, if we take the Conservative Model Portfolio that boasts an anemic total equity allocation of only 30%, there is only a combined allocation of 0.11% in Turkey and the other “problem” countries. Nice!

This is Financial Planning done right!

Regards,

Rick Van Der Noord, CFP®

Dave Gerdt, CFP®

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