Stick with US stock funds

Financial planners often advise their clients to diversify their investment portfolios in order to minimize their level of risk. Diversification, as we all know, merely means that you don’t put all of your eggs in one basket.

Investors, ideally, should allocate their assets according to their age, goals, circumstances, and tolerance for risk: A young single person should own more stocks than bonds; an older person closer to retirement should have more cash and bonds, rather than substantial equity holdings, which tend to be more volatile and threatening to his principal.

Since most of us don’t have enough money to adequately diversify our assets along individual stocks and bonds, we generally turn to mutual funds, which offer us a truly broad range of diversification, for relatively little money ($5,000).

With mutual funds, we can invest in all kinds of stocks: large cap stocks (big companies), mid cap stocks (medium sized companies), and small cap stocks (small companies). We may even invest in gold or other specialized sectors, including healthcare, financials, and high technologies.

Mutual funds even come in international flavors, with some funds specializing in Asia (regional), others in Europe, and still others all over the world (global), including the United States.

For most financial planners, a truly diversified portfolio of mutual funds should include large cap, mid cap and small cap US stock funds, along with an international (foreign) fund and a defensive bond fund. The US stock funds could even be divided further, into growth or value, blend, growth and income, aggressive growth, balanced and other categories. But we will leave those distinctions aside for now.

For now, I’d just like to make the case that, contrary to conventional wisdom, foreign funds are not at all needed for proper investment diversification.

For one thing, foreign funds generally cost more than domestic funds; their annual expense ratios are substantially higher than US funds, giving you less of an overall return.

Secondly, in a globalized economy, foreign markets tend to work in tandem with our own domestic market. When the Dow soared to a record high last week, Japanese stocks were also lifted. Conversely, when Asian markets swooned last year, the Dow dropped more than 500 points. World markets increasingly follow each other, thus obviating the need for foreign fund exposure.

Thirdly, foreign funds have performed horribly over the past several years. In fact, foreign funds have not had a good year since 1993 — five years ago. Emerging markets have become submerging markets, while the US market continues to rise.

Finally, foreign market exposure is already available through large cap, multi-national American companies — the most efficient, productive, technologically-advanced and sophisticated companies in the entire world.