International stocks are supposed to help diversify a portfolio. What happens, though, when foreign companies are swept up into globalization and those companies become less foreign? Are you still as diversified?
A study last year from Merrill Lynch showed that U.S. and foreign markets perform more in tandem now than they did a few years ago. The so-called correlation between the Standard & Poor's 500 and the Morgan Stanley Capital International EAFE (a benchmark for international stocks) over five years that ended in early 2006 was 96 percent, up from 32 percent over the five years that ended in early 2000.
If domestic stocks have a bad year, then there is a greater chance your international holdings will, too. A truly diversified portfolio should include some assets that "zig" when others "zag."
Financial planners insist, though, that diversification is possible, especially as new opportunities to invest abroad open up. Some strategies to consider:
Start at the core.
If you are just starting to build a portfolio, you probably don't have the cash to diversify through multiple funds.
Not a problem, said Bob Mecca, a financial planner in Mount Prospect, Ill. He suggests picking a global fund, which invests in U.S. and foreign stocks.
The Vanguard Global Equity fund, for example, invests 46 percent of its assets in U.S. stocks. The rest is directed to Europe, Japan and elsewhere in Asia.
A global fund also isn't restricted to specific countries or industries, giving the fund's managers the flexibility to move money around the globe as different markets heat and cool.
"You leave it up to the manager to pick and choose where he wants his allocation overseas and in the U.S.," Mecca said.
One issue is that if you hold a domestic stock fund, it could invest in the same U.S. companies that a global fund finds attractive, creating overlap, not diversification.
For example, Pfizer Inc. is one of the top holdings in the S&P; 500 and the second-largest holding in Vanguard's Global Equity fund.
In that case, you probably are better off with an international fund that invests solely in companies headquartered abroad.
Diversify across regions and size.
With your bases covered, globalization is still an issue: You are investing in companies overseas, but what happens when those firms do a lot of their business in the United States?
As your portfolio grows, consider adding funds from areas of the global market that might not have a large, or any, presence in a typical international fund.
Small-cap foreign funds and emerging-market funds are two to consider, said Matthew Kelley, a financial planner in Boulder, Colo. Without mega-companies that straddle U.S. borders, these funds may have a lower correlation with U.S. stocks.
They also could produce juicier returns. For the last four years, emerging-market stocks have returned more than 30 percent on average annually.
Just keep in mind that the downside can be equally dramatic, and emerging markets' four-year winning streak could mean the category is ready to cool.
"You always have to remember that huge returns are coupled with huge risk," said Lisa James, a financial adviser with Merrill Lynch in Chicago.
Look at categories.
Another option is to look abroad in other investment categories, such as real estate investment trusts and bonds.
David Siopack, a portfolio manager for the Schwab Global Real Estate fund, contends that, historically, real estate has a lower correlation to stocks, cash and bonds.
The correlation can be even lower abroad.
"Real estate is a very localized business," Siopack said. "Demand for office space in downtown Tokyo has mushroomed, while markets in some U.S. cities have really started to plateau."