Should U.S. Investors Invest Overseas?

I nterest in foreign investment has been high among U.S. investors in recent years. The unprecedented growth of 401k pension plans has greatly increased the number of people who must make their own investment decisions in planning for their retirement. Many investors know that geographic diversification can improve investment returns without increasing risk. However, whether or not to invest abroad and, if so, how much weight to give to foreign investment, are questions often subject to heated debate. Some investment advisors recommend that U.S. investors put as much as one-third of their stock portfolio in foreign stocks to take advantage of the benefits of diversification. Others believe that foreign investment should play only a small role, if any, in a U.S. investor's stock portfolio. They argue that political uncertainties and currency fluctuations make the value of foreign investments far more volatile for the investor without the offsetting benefits of higher returns, and that diversification benefits are not enough to offset this disadvantage. 1 Moreover, U.S. investors can get overseas exposure by investing in the stocks of domestic companies. Many U.S. multinationals that are part of the Dow Jones Industrial Average, such as IBM and Coca-Cola, derive a substantial portion of their revenue from overseas operations. The question of whether or not to invest abroad is part of the larger question of how to assemble a portfolio that is appropriate for the investor's circumstances and degree of risk tolerance. Modern portfolio theory, introduced by Markowitz in the 1950s, uses optimization techniques and historical data on the returns, risks, and correlations of available securities to construct a portfolio with the lowest possible risk for a given level of return. The theory has been widely accepted for almost half a century, and it has found practical applications among pension funds and other institutional investors in the past 20 years. Because of heavy data demands and computational intensity, however, it has largely been out of reach of individual investors. With the advent of cheap computing power and the Internet, commercial services are