How much should you put in international stocks?

(MoneyWatch) Many investors prefer to keep their investments in places or companies they know. For example, many people are heavily invested in domestic stocks even though the U.S. makes up only 44 percent of the world's market capitalization.

Of course, not everyone should follow the same split, so today, we're going to see when you should increase or decrease your allocation to stocks abroad.

Before we launch into your allocation decision, let's review why many people allocate very little, or not at all, to international stocks. At first glance, there doesn't seem to be much benefit to diversifying away from domestic stocks into international stocks. From 1970 through 2011, the S&P 500 Index returned 9.8 percent, and the MSCI EAFE Index returns 9.6 percent. However, there have been long stretches when U.S. stocks performed relatively poorly while international stock performed relatively well, and vice versa.

Thus, the gains from international diversification come from the relatively low correlation among international securities. While the S&P 500 outperformed the MSCI EAFE for the period 1970-2011, a portfolio that was 60 percent S&P 500/40 percent MSCI EAFE and rebalanced annually would have returned an even higher 10.0 percent.

Tracking error

Gaining the benefits of diversification also means dealing with tracking error risk. In short, tracking error is the difference between your portfolio and its benchmark. In good years, when your portfolio is beating the benchmark, you're probably pleased with the results and not giving tracking error much thought. However, in other years, you could end up panicking and wondering if you're in a bad portfolio if you trail by a few points. Tracking error becomes much more likely if you're allocating to international stocks while benchmarking against a domestic index such as the S&P 500.

With the facts and behavioral issues in mind, let's examine reasons why you might consider higher or lower international allocations.

Reasons to increase overseas stock allocation

Reduced Risk. The historical evidence suggests that raising the international allocation to at least 40 percent reduces portfolio risk (volatility). Also, if your job is most at risk when the domestic economy is bad, an allocation of 50 percent or perhaps even a bit higher may be appropriate.

Non-U.S. dollar expenses. If you travel overseas frequently or even live overseas part-time, you may want to tailor your portfolio to gain specific exposure to the currency in which the expenses are incurred. This could also be accomplished by making fixed income investments in the local currency.

Reason to decrease overseas stock allocation

Costs matter. While international assets provide an important diversification benefit, international investing is more expensive because of higher trading costs, higher fund expenses and the lack of the foreign tax credit (if investments aren't held in a taxable account).

Not reasons for either

Currency risk. Many investors cite currency risk as a reason to avoid international stocks. Currency risk is the risk that gains or losses from international stocks can be neutralized by the value of the country's currency rising or falling against the U.S. dollar.

However, currency risk is a two-way street. There's just as much risk of the dollar falling in value as there is that it will rise in value. A falling dollar can impact your standard of living, acting just like a tax on imports that increases their costs. It can even increase the price of domestically produced goods because the producers are now competing with more expensive imports.

As far as your returns go, a drop in a foreign currency's value tells you nothing about the dollar returns you might earn. For example, in 1956 the British pound was worth about $2.80. At the end of 2011, it was worth about $1.60. Despite the drop, U.K. small-cap stocks returned 14.2 percent per year in dollar terms, while U.S. small-cap stocks returned 11.9 percent over the period 1956-2011. All else equal, a falling currency makes a country's exports cheaper and its imports more expensive, helping both companies that export and those that compete with imports. And the reverse of course is also true.

Adding unhedged stocks. While currency risk has increased the volatility of an all-stock portfolio, adding unhedged international stocks to a stock/bond portfolio hasn't!

• For the period 1970-2011, a portfolio that was 60 percent S&P 500/40 percent five-year Treasury Notes returned 9.52 percent, with an annual standard deviation of 11.14 percent
• A portfolio that was 36 percent S&P 500/24 percent MSCI EAFE/40 percent five-year Treasuries returned 9.67 percent and did so with an annual standard deviation of 11.07 percent.

As you can see, the portfolio that included the allocation to the MSCI EAFE had slightly higher returns and slightly lower volatility. The reason is that the annual correlation of the MSCI EAFE to the S&P 500 was just 0.66 and was actually negative (-0.14) to five-year Treasuries. This example is a powerful demonstration of why you should never make the mistake of considering assets in isolation.