Choosing An Asset Allocation, Step 2: Deciding On The Domestic/International Ratio

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I don’t know if this is the proper next step, but after deciding on a stock/bond ratio for myself, I want to think about the specific breakdown of stocks (equity). As mentioned when talking about investing in total markets, you could simply “own the world” using just two funds or ETFs and weighting them according to market capitalization – using one Total US fund and one All-World Except-US fund:


If you use the ETFs, the total weighted expense ratio would be a mere 0.17% annually!

Concerns About Investing Abroad
However, according to various surveys the average US investor has much less than 55% of their equity portfolio in international stocks. Here are a few reasons that have been cited:

  • Country/political risk – This includes the possibility that the economy of certain countries could collapse due to war or other internal strife. Also many governments have less oversight and transparency than the US and other developed countries.
  • Currency risk – These days it seems like people want to hedge against a falling dollar, but only recently people were worried about a strengthening dollar affecting international investments. Either way, it does add an element of risk.
  • Added cost – Investing in international mutual funds usually cost more in management fees.
  • Existing exposure – Some statistics show that a very large chunk of revenue from US-based companies now come from outside our borders, so even without adding international companies we are already being exposed to many of the same effects. This also explains the recently increasing correlation between domestic and international stocks.
  • Performance-chasing – Recently international funds have been on a very good run. Some believe this is the main factor in increasing foreign exposures, as opposed to fundamental factors.

Historical Risk/Reward Relationship – Benefits of Diversification
On a very general level, the reason to invest in international stocks as it pertains to Modern Portfolio Theory is that you get a diversification benefit. Historically, international stocks in general have had higher average returns, but also higher risk (volatility). But due to low-ish correlation, mixing domestic and international stocks has resulted in less risk and greater return.

Below is a chart taken from the book A Random Walk Down Wall Street. It maps the risk/return for portfolios that range from 100% US stocks to 100% EAFA (Developed countries) for the period January 1970 to June 2006:


As you can see, with 24% EAFA and 76% US, you can achieve higher return with less risk. (70% is a typo.) Even if you go with more international, you can reach a point where you get the same risk as with a 100% US portfolio, but higher return (as much as 45%-ish?). As always, this is based on the past and is not guaranteed to persist. But again, all we have is history – here we are talking 35 years.

Okay, So How Much Is Best?
Shrug. So far we have sort of defined a range from ~25% to about 55% international. One helpful paper is presented by Vanguard Research – International Equity: Considerations and Recommendations. It’s a good read, but here is the conclusion:

In light of quantitative analysis and qualitative considerations, we have demonstrated that domestic investors should allocate part of their portfolios to international securities and that a 20% allocation is a reasonable starting point. While adding an allocation of 20% to 40% has historically been beneficial, adding too much can increase portfolio risks without the commensurate benefits. Finance theory dictates that an upper limit should be based on the global market capitalization for international equities (currently approximately 50%). However, we have demonstrated that international allocations exceeding 40% benefit a portfolio incrementally less, particularly as costs are accounted for. Although no absolute answer exists for all investors, it should be clear that an allocation range of 20% to 40% is reasonable given the historical benefits of diversification. Allocations closer to 40% may be suitable for those investors less concerned with the potential risks and higher costs of international equities. Allocations closer to 20% may be viewed as offering a greater balance among the benefits of diversification, the risks of currency volatility and higher correlations, investor preferences, and costs.

What Do The Target Retirement Funds Say?
Again, we refer to the popular all-in-one funds by Vanguard, Fidelity, and T. Rowe Price. Let’s just take their 2045 funds and dissect them using Morningstar X-ray:


Hmm… 20-26%.

My Decision
I feel that going forward, both US stocks will be more influenced by outside countries, and international companies will be influenced by the US. They will all fight it out. Maybe the US won’t be the dominant world power anymore. In that way, I like the idea of investing in a world-cap weighted portfolio. However, the fact remains that I will most likely be retiring in the US and be spending US dollars. So there should be a slight home bias. Fortunately, this is also supported by the historical risk/return characteristics. Finally, international investing does cost more, although the difference is shrinking.

To be honest, this is where I am having a hard time making a decision. I am hovering between 30%-40%, and leaning towards 40% foreign. What do you think?

Read more: Index of Posts On Building My Portfolio

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  1. Jonathan,
    I recently read the same article by Vanguard when I was working on making our asset allocation more simple. I decided that my approach would be to have 20% this year, and increase it by 5% each year until I hit 40%. One consideration to take into account are the tax impacts of rebalancing.

  2. Did you consider Vanguard Total Intl Stock Index VGTSX ?
    This one has a lower expense ratio 0.32% versus VFWIX (0.4%).
    VFWIX has a purchase fee of 0.25%.
    VGTSX holds other Intl indexes while VFWIX holds foreign stocks.

  3. I’ve tried to stick as close to 40% as possible. I figure that’s the best return without getting stupid risky. I like to take on as much risk as possible though.

  4. A fund with foreign blue chips has been recommended by some financial advisors as a way to diversify out of the dollar and stay a bit ahead of its devaluation.

    It is something I would like to do.

  5. Ted Valentine says

    Regarding VGTSX and VFWIX, the general line of thinking is use VGTSX for tax sheltered due to lower cost and VFWIX for taxable due to the foreign tax credit. If you’re going to use ETFs then the only choice is VFWIX.

    The difference is VGTSX is a fund of 3 funds, the Europe, Pacific, and Emerging Stock Indexes and VFWIX is a total international fund holding individual stocks. One difference people like to point out is that VFWIX holds Canada and VGTSX doesn’t. Also any countries not represented by the Europe, Pacific, and Emerging Market indexes may be in VFWIX but will not be in VGTSX.

    When its all said and done the difference between the two funds is slight, and unlikely to make a difference in the short term. Long term is anyone’s guess. You really can’t go wrong either way. I hold all my international in tax sheltered, so I’m sticking with the tried and true VGTSX.

  6. i am currently at 40% intl, using VGTSX. when i rebalance in january and eliminate the one equity i was holding (5% Altria) i believe I will be reallocating this 5% to VGTSX.

    that would put me at 45% intl, which i feel is correct for where i see the world economy in 40 years.

  7. Drew Miller says

    From that graph it seems like the more, the better, although I would like to see an averaged weighting rather than growth from one particular day. I am going to go 50/50 I think.

  8. The world landscape has changed dramatically over the last 30 years, with the end of the Cold War and Russia/China turning into Robber Baron capitalists. The US is still a huge force (artifically depressed over the short term due to the Iraq war and housing problems), but one must avoid seeing the future through 1950s-1990s lenses.

    Emerging markets, as lead by the BRICs (Brazil, Russia, India, China) are the growth stocks of this era and similar to Japan from WW2 through the 1980s. They have been on a tear and no one known when it’ll end. Just now people are starting to call EM a bubble–meaning there’s probably 2-5 years left before a temporary crash. Over the mid term their performance may well resemble dot com stocks. For all the reasons you mentioned, EAFE is almost the same as US stocks.

    My conclusion: it makes sense over the long term to go 40% US, 40% international, and 20% cash/bonds. The international portion should have a *dedicated* and *significant* EM focus, however at current values try to buy during corrections. For any funds you seek to use in less than 10 years stay below 20% international and consider EM pure speculation.

  9. I believe that VFWIX has a few countries that VGTSX skips, like Canada.

    I think there is now an all-world SPDR (US and international) but I can’t find it right now.

  10. Oops, sorry, that ETF will be a Northern Trust ETF, and it’s not quite out yet.

  11. Swim Upstream to Wealth says

    Great post and very important. Most Americans have less than 5% of their equity allocation to international, which is a huge mistake. Another study from Vanguard discusses the optimal amount of your equity position being 30% international. While the international markets comprise 60% of the world’s capitalization, it still cost more to invest internationally so 30% seems to be a good spot. As Ryan posted above, he is 45% in anticipation of the continued world growth, which is certainly a wise point.

    However, I am not a fan of using one ETF for international exposure. For developed international markets, I allocate 50% to the Vanguard Pacific ETF and 50% to the Vanguard European ETF. If you read the works by Rick Ferri, you can actually capture 10bps through rebalancing by holding equal allocations to the two areas of the world. Vanguard’s VGTSX is much heavier into European markets and holds all most as much emerging as Pacific. The reason holding both Asia and Europe in equal amounts adds value is the two areas have lower correlations and move differently. If you look at the EAFE in the 80s it was almost all Asia due to Japan’s dominance. Then by the late 90s it was Europe and still leans that way today. So you can pick up some return by splitting the two and rebalancing assuming the extra transaction cost doesn’t eat the extra return.

    Also, you should look to add international small cap to your portfolio. This asset class has the lowest correlation to US stocks since many of the companies conduct a large percentage of their business within their own backyards as most small caps do. I like the Wisdom Tree International Small cap dividend. For 60 bps, you can’t find this asset class any cheaper, and it favors value companies since it is a dividend focused ETF.

  12. I’ve been fairly heavy into international stocks this year (not performance chasing). While I don’t have 35 years of investing experience like the graphs above, I can second them. Since my horizon (and I’m assuming yours too) are at least a couple decades off, I can weather the volatility now for a higher return. I say go 40% 🙂

  13. The current mix of VGTSX is

    Vanguard European Stock Index Fund 56.1%
    Vanguard Pacific Stock Index Fund 24.8%
    Vanguard Emerging Markets Stock Index Fund 19.1%

    I don’t believe it’s normally like this. I’d assume re-balancing is coming. Earlier this year, I think emerging markets was only about 5%.

  14. Why not put 50% or more international? If anyone were to say, put 80% of your money in Spain, they would be deemed crazy enough, but we seem to think that US is somehow special and less risky or volatile than the international markets to only put 20-30% in international!

    Given the deteriorating economic condition, increasing national debt, subprime mess, weak dollar, it is no surprise that the US market is struggling in the 13,000 mark for the Dow, whereas markets such as India BSE Sensex have gone from the 13,000 to almost 20,000 in the same time period.

    There are many ETFs and closed funds with management funds not greater than other actively managed funds. e.g. INP tracks the India BSE Sensex, VWO – the emerging markets etc. My strategy is to put around 50-60% international, 30-40% domestic; and even then split the domestic into specialized sectors like REITS etc which may also have international exposure.

  15. InvestRequest says

    Keep in mind that most domestic equity funds have a fairly significant portion invested overseas as well or domestically from company’s that derive a large part of their business from outside of the US.

  16. Dude, if you go up to 40% instead of 20% you are increasing your return by only 0.4, but you are exposing only 3 or 4 more risks!

    I personally don’t think that trade off is worth it.

  17. My portfolio includes 40% of foreign stocks and it?s a quite good balance. I?d like mention that while optimizing your portfolio you?d better use portfolio analysis programs. So far, I haven?t found such program which could meet all my requirements to penny stock portfolio. Can you advise something?
    For my age, it?s too early to think of retirement and investing in retirement funds, but your article enforced me to think of this.

  18. MyDollarPlan – I think that’s a good idea as well.

    Sudip – Ted Valentine’s comment explained it better than I could. It’s very close, especially if you are in a tax-sheltered account.

    Swim – Thanks for the suggestion – I have read Ferri’s writing on holding Euro and Pac separately. I’m not sure the chances that such a *expected* 10 bps improvement will hold in the future are great enough to bother with that. I am going into Value/Size tilting in a later post.

    Greg – What data are you basing your comments on? 4x more risk?

    Fox – I haven’t found many free MVO (mean-variance optimization) programs. I have some links somewhere, which I’ll dig out for the last part of this series.

  19. Jonathan/Fox, I am also interested in any portfolio analysis software. But I bet it is costly. Does anyone have a handy spreadsheet?

    Jonathan: I didn’t say 4 times the risk, I said 3 or 4 more types of risk (depending what you define as risk) as our blogger hosted mentioned they are. (e.g. Country/political risk, Currency risk, Added cost, Existing exposure). John Bogle also mentioned the same, international carries more kinds of risks.

    For me, that’s 3 or 4 more times ways that the price will fluctuate and get me frustrated. I’d rather not put up with it.

  20. Looks like you’ve done a lot more research than I have on this, but I’m currently at 50% if that makes you feel any better. The economy is obviously becoming more global and we need to adjust our portfolios accordingly.

  21. sfordinarygirl says

    After reading these comments I’m seriously considering rebalancing my 401(K) portfolio. I chose to allocate 25% of my portfolio to the Vanguard total international stock index fund and the international value fund. The risk seems extremely high at 40% for international funds even though the Us economy is tanking. And I get the sense China’s boom ride is over wtih the lead paint scandals and frequent recalls.

  22. Jonathan,

    I’ve been using a two-fund, world-weighted equity portfolio for a while, the only difference being that I pull my target weighting from the monthly issue of the FTSE All-World Review (you can sign up for their email by indicating you’re an institutional investor).

    Currently, the “ex-US” portfolio weight is 58.67%, a bit higher than the figure you’re using.

  23. One way to avoid losing the foreign tax credits when buying the fund of funds (Vanguard Total International Fund), is to simply buy all three underlying funds and reallocated to the mix that Vanguard maintains in their Total fund (or use the Portfolio analysis on their website, if your accounts are with them). You can also add iShares Canada to get the true world ex-US, as the Vanguard Total International Fund excludes Canada. (Also VEU underweights Canada somewhat.) Back to the main point, if you own all three underlying funds, the FTCs flow through to you for writeoff.

    Swim–You mention some Vanguard study saying 30% international is optimal. Can you or someone else provide a reference?

    Stephen–Yes, EM has been increasing for quite a while and that allocation is correct, or close–not 5% EM anytime recently.

    Excellent blog focused on something I’ve been pondering myself for some time, especially in light of anticipated demographic changes. I would like to see that chart from A Random Walk redone with MSCI AWCI ex-US vs. US Total Market (Wilshire 5000). I bet that the sweet spot would be higher than 24% international. EAFE vs. S&P500 is not the best data set. Can anyone run that regression? Or does anyone know of such analysis?

  24. In addition to using the new Vanguard all world ex-US FTSE fund (with .40% and .25% ER for the Investor Shares & ETF, respectively) as suggested in the blog, one could create an all world ex-US international portfolio by using:
    CWI (newish SPDR) ER .34%
    VGTSX ER .32% (plus 6% iShares Canada EWC ER .52%), avg combined ER .332% (no flow through of non-Canadian FTCs)
    or in the separate Admiral Shares plus 6% EWC ER .213% (w/ FTCs)
    or in the separate ETF Shares plus 6% EWC ER .157% (w/ FTCs)
    or in Vanguard’s Tax-Managed Intl Fund (VTMGX) plus 6% EWC ER .219% (w/ FTCs)

    6% is the curent proportion that Canada makes up of world ex-US.

  25. Toe Dipping says

    I’m currently at a very low 14% international and looking to increase. My worry is an increasing dollar and the chasing returns. The upside is that there have been several notes about major orgs (Texas teachers pension, Florida state pension, NY something pension) that will be increasing their international exposure. How much so I go up? To the 20, 30 or 40 percent range? It’s the risk of the dollar that has me really worried.

  26. Jon-

    What source do you use to calculate the world stock market breakdown by region? I thought I followed a good link off the site to a Vanguard page showing several pie charts breaking down the the total investable world stock market capitalization by region, but can can no longer find it. Any help? Btw, congrats on your blog’s success!

  27. US market used to be 55%, then 45%, now 30% of world market! Source:
    I wonder if the reasonable range of foreign investment (which seemed to be 25%-45%) in that Vanguard white paper would increase, given the relative decline in the value of the US market (partly due to relative stock prices, partly due to the decline of the dollar).
    I am at 35% (owning underlying funds of Vang Total Intl Fund), but would like to go higher (40, 45, 50%?). Now it is a timing question–when? Will the dollar ever rebound–somewhat?

  28. Correction: The Vanguard white paper suggests that the reasonable range of foreign stock investment is 20-40%. Also the data period that their analysis is based on is 1970-2005 and includes a range of US proportions of the global market from 30-70%, so we are still in that range (lower end). Re-reading that paper, I have decided that moving from 35% to 40% foreign would essentially be a bet in favor of foreign stocks (or against the US dollar).

  29. Can I just say – AWESOME BLOG! We are on the same wavelength. I should review my allocations more often…it has been years, but that’s what having kids will do to you. I think I am going to do 35% international. I see the US has to level with the international market in the future and relatively speaking, I think we have more currnency risk than at any point in the history data on the chart, but feel it is somewhat balanced by the international influence on U.S. stocks.

  30. I think that we are in a secular bear marker which started in 2000 (after the tech bubble bust), and will continue to go on for next 8 years. In this secular bear market, we will see lots of cyclical bulls (that we are seeing today but soon will be lead by an another cyclical bear). Given this situation, I feel one should be take a reasonable risk for a reasonable return. Therefore, I was thinking about allocating 40% stocks and 60% to bonds, and then further allocate between US/International. Here is what I was thinking 20% US stock, 20% International stock, 30% US bonds, and 30% International bonds.
    Any comments?

  31. I have 30% allocated to DODFX International Funds in my 401k plan. It is the only international fund I have to pick from but the expense ratio is 0.64%! Should I invest in my IRA or something aside from my 401k/IRA? After reading about the 0.32 rationI feel like this is too high.

  32. Stephen B says

    Nice Website Jonathan! Thanks for your efforts!

    It sounds like we have a similar mindset and age-31 (also I’m a engineer). I’ve read the IFA and Bogle books. I personally think most people are way too focused on domestic (US) equities. I, like you, think the true global market cap weights are a good starting point – ~40-45% US & 55-60% International. With the US national debt increasing, rates at 0%, and the money printing, I would expect in the long term the dollar will fall vs. most international currencies, especially EM due to higher int rates, no/low debt, and higher GDP. I think it’s important to diversify from the dollar, I think it’s inevitable that it will not remain the only world reserve currency. Also since US citizens income stream (jobs, salary, pensions, social security) and real estate are all dependent or at least correlated to the US economy, one should diversify at least some of their assets away from their income stream. This is the same argument as why not to invest in the company that you work for. I don’t think emerging markets are as risky as most people believe. I think as their markets have matured and grown, volatility (std dv) will come down from where it has been historically. They have debt, deficit, and demographics way better than the US. Dividend yields are higher, div growth rates are higher, earnings growth rates are higher, GDP is higher, and P/Es and book values are lower. What’s not to like? I personally put all my international exposure in EM since also they are lower correlated with the US. My portfolio is 50% US. 50% EM with a small cap and value lean (IFA). I think the small cap and value lean in EM is important, value should help reduce volatility and small cap will have lower correlation with US and focus more on the rapidly growing middle class market consumers. Also a big fan of Vanguard products, also trying out a couple Wisdomtree products. I think alternate cap weighting vs. market cap weighting is a valid argument if one can still keep costs low, also dividend weighting provides a value lean and I think protects downside risk.
    12.5 – US Lg Blend – VTI
    12.5 – US Lg LV – VTV
    12.5 – US SM Blend – VB
    12.5 – US SM Value – VBR
    12.5 – EM Lg Blend – VWO
    12.5 – EM Lg Value – DEM
    12.5 – EM SM Blend – EWX
    12.5 – EM SM Value – DGS.

    Any comments?

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