Friday, December 12, 2008

International Over Diversification

This post originally appeared on TheDiv-Net one week ago

Most investors are told that they should hold a diversified portfolio of stocks, bonds and real estate, each of which would have several subcategories for further diversification. Stock investors are typically encouraged to hold at least a certain portion of their share holdings in international shares, rather than stick with domestic only stocks. The rationale behind this idea is that not all economies follow the US economic cycle, which could possibly prevent investors from losing money if the US stock market crashes while international markets decline less or even increase. In fact, investors who had an allocation of foreign stocks over the past decade did outperform the US benchmarks, as international stocks rose more than their US peers.

This year however most global funds are down much more than the major US benchmarks. The reasons for this underperformance include the strong dollar in 2008 as well as falling prices worldwide after a five year bull market. It does feel as if an international exposure could be beneficial in the long run, its positive effects haven’t been felt so far in the credit crisis of 2008. Furthermore, most US investors who are purchasing domestic stocks, are most likely to own several large multinational behemoths which derive a large portion of their revenues from abroad.

In order to conduct my experiment, I selected the ten largest companies by market capitalization from the S&P 500 index. The ten largest S&P 500 stocks account for over 22% of the daily fluctuations in the index. So what is the portion of financial results that these large cap companies derive from abroad?

It is interesting to note that few of the companies listed above broke down the contributions of their global operations in different formats. Some of these breakdowns focused on revenues, while others focused on net income or income from continuing operations. Adding to this is the fact that most of the companies close their books annually on different dates.

Despite the limitations of the data available for public use in relation to actual international operations in some cases, I think that on average the findings present an interesting way of looking into the issue of international over diversification. It seems to me that if the ten stocks with the highest weights in the S&P 500 index derive about 44% of their aggregate financial contributions from foreign operations then the overall contribution to financial performance would be similar for the index as a whole. Thus an investor, who is simply invested in an S&P 500 index fund, is also properly diversified internationally.

As a dividend investor, I have occasionally expressed concerns that I can’t find enough international dividend growers with a history of growing their dividend payments for over one decade. After conducting this experiment, I can see that most of the large cap multinational dividend stocks that I cover in this blog are good proxies for global market performance. Adding any further international stocks could increase my international exposure, without adding any further incremental benefits.

Full Disclosure: I own shares of GE, PG, JNJ and WMT

Relevant Links:

- International Dividend Achievers for diversification

- Attractively Valued International dividend stocks

- My Dividend Growth Plan - Diversification

- Why should companies pay out dividends?

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