International Investing Myths You Shouldn't Believe

Last Updated Sep 26, 2011 10:45 AM EDT

My Right Financial Plan co-author Kevin Grogan recently took a look at rebalancing myths investors shouldn't believe. Now, he looks at a few myths involving international investing that should be put to rest as well.

The first myth I will discuss is that investing in countries with high economic growth rates will lead to higher equity returns. Before you invest in these countries, be sure to take a look at the evidence.

The key thing to remember is that markets are highly efficient and that estimates of future growth are built into current prices. University of Florida professor Jay Ritter found that the correlation of GDP growth and stock returns was negative. The talented research team at Vanguard has found similar results.

There are three main reasons why we would expect economic growth and equity return to have a negative correlation.

Benefits of Growth The benefits of economic growth may not necessarily go to equity investors. The increased productivity could result in higher real wages instead of profits.

Multinational Companies Most large companies are multinationals. The profitability of these companies depends on worldwide economic growth as opposed to the growth rate of a particular country.

Expected Growth High expected GDP growth is built into current stock prices. If a country is expected to see strong growth, it's perceived to be a less risky place in which to invest. Because you're compensated for risk, your expected return should be lower since your perceived level of risk is lower.

The fact that GDP growth and equity returns are unrelated doesn't mean you should avoid emerging markets altogether. Investors are best served by allocating their investment portfolios roughly the same as world market caps. Further, investors should expect higher returns from emerging markets because they're riskier, not because they have high growth rates.

The second international investing myth I'd like to discuss is that investing in U.S.-based multinational companies is all that's required for international diversification.

Before you fall for this myth, take a look at the data. The U.S. represents just 45 percent of world market capitalization, so if you only invest in U.S.-based companies, you're missing out on more than half of all investment opportunities.

Let's take a look at the annualized returns of two portfolios (rebalanced annually) over the past 10 years:
  • 100 percent S&P 500 Index -- 1.4 percent
  • 60 percent S&P 500 Index/40 percent MSCI EAFE Index -- 2.3 percent
While the results above show the benefits of diversifying into international large companies, the real benefits from diversifying internationally come from diversifying into international small companies. The logic is clear and simple. Many large companies are global giants, selling all over the world. Their earnings will clearly be impacted by global conditions. On the other hand, many smaller companies depend more on the condition in their local economies. The data bears this out. International small stocks have a low correlation with international large stocks, U.S. large-cap stocks and U.S. small-cap stocks.

Certainly there are time periods -- such as specifically market crises -- where the benefits of international diversification aren't as apparent. If this poses a significant risk for you, allocate some amount to high-quality fixed income assets to keep the risk of your portfolio at a level consistent with your ability, willingness and need to take risk.

More on MoneyWatch:
Rebalancing Myths That Need to Be Debunked 9 Bits of Conventional Wisdom You Should Ignore Passive Management Wins in Emerging Markets The Issues With Socially Responsible Investing Why You Should Absolutely Avoid Absolute Return Funds
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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