Find a Fortune Overseas

Do you have enough international stocks in your portfolio? If not, you may feel like you've missed the boat on big profits.

By nearly every measure, stock markets in foreign countries have been going nuts for several years running. Hit hard by the U.S. bear market from 2000 to 2002, world stock markets, as measured by the MSCI EAFE index, have risen at a faster pace even than stocks here at home.

Over the past five years, the index is up over 15% annually. During the past three years, the yearly rise has been closer to 20%. Compare that to the S&P 500, which is up nicely, but at a slower rate: less than 11% annually since 2002, and less than 12% per year since 2004.

Fear and greed

With such strong past performance, you'd expect that average investors would be jumping on the international bandwagon. And you'd be right -- when you look at recent inflows into stock mutual funds, you can see that month after month, investors have shown a strong preference for international funds over those holding domestic stocks.

Yet just as the rise of real estate investment trusts in the late '90s has continued largely unabated by valuation concerns, international stocks have shown few signs of slowing down. The emerging Chinese stock market briefly dropped earlier this year in a panic session that sent waves of fear rippling around the globe, but Shanghai quickly rebounded to new highs, and world markets soon resumed their upward moves. Continuing worldwide demand for basic materials has given global companies like Mexican cement-producer Cemex (NYSE: CX), Chinese energy giant Petrochina (NYSE: PTR), and Australian metals producer BHP Billiton (NYSE: BHP) strong fundamental support for rising stock prices.

Yet like a game of musical chairs, you don't want to be the last one to buy into soaring international stocks before the inevitable correction occurs. Even if you take a long-term approach to your investing strategy, buying in at the highs can cost you a significant fraction of your overall returns.

Is 10% enough?
Traditionally, many financial advisors recommended that investors keep most of their stock investments within the U.S., typically allocating just 10% or so to foreign stocks. Planners argue that lower levels of investing regulation, less transparent financial disclosure, and political and economic instability support a conservative approach to allocating money to foreign markets.

However, just as REITs have benefited from the increasing willingness of planners to divert some of a client's fixed-income allocation away from bonds, advisors are now taking a second look at the 10% rule for international stocks. With the global economy continuing to evolve, national identity among corporations becomes less important every year. Perhaps the most obvious example is in the automotive industry, where Japanese manufacturers like Toyota (NYSE: TM) and Honda (NYSE: HMC) have built plants in Kentucky and Indiana, while American makers Ford (NYSE: F) and General Motors (NYSE: GM) have manufacturing plants around the world. Given that the U.S. economy makes up only about a quarter of the world's gross economic product, ratcheting up international stock allocations even an additional 5%-10% makes plenty of sense -- yet it could also have a huge impact on stock valuations going forward.

It's true that even if you only own American stocks, you have a wide exposure to the worldwide economy. However, in the same way that diversifying across sectors of the economy is prudent to avoid risk to specific types of companies, diversifying across national borders can give you some protection against an economic downturn that hits a particular country hard.

Finding your fortune
One other objection many investors have is that learning about companies across the world can be more difficult than researching U.S. companies. The nuances and subtle differences in the way people do business around the world require analysts to think outside the box in making judgments about how well a company might be able to perform in the global marketplace.