Getting Going

Two Pros Clash on Merit of Foreign Stocks

By Jonathan Clements
The Wall Street Journal
Page C1
(Copyright (c) 1999, Dow Jones & Company, Inc.)


When it comes to investing, John Bogle and Burton Malkiel speak the same language -- until you ask them to venture abroad.

Mr. Bogle is senior chairman of Vanguard Group, the large Malvern, Pa., mutual-fund company. His friend Mr. Malkiel, an economics professor at Princeton University, has been a director of Vanguard's funds for the past 22 years.

Both are vocal advocates of market-tracking index funds. Mr. Malkiel wrote "A Random Walk Down Wall Street," the 1973 classic that provided possibly the most persuasive argument for indexing ever.

Three years later, Mr. Bogle launched the first index fund, Vanguard 500 Index Fund, which tracks the performance of the Standard & Poor's 500-stock index. "We tend to see eye to eye," Mr. Malkiel says.

But when it comes to foreign investing, their positions couldn't be further apart. Mr. Malkiel, 66 years old, argues that U.S. investors should have as much as a third of their stock portfolio in foreign stocks. Mr. Bogle , who is four years older, believes investors shouldn't put more than 20% abroad, and he thinks a zero weighting is just fine.

"I am not persuaded that international funds are a necessary component of an investor's portfolio," Mr. Bogle argues in his new book, "Common Sense on Mutual Funds."

The differences between these two luminaries highlight the debate raging among U.S. investors. Lately, U.S. shares have so trounced foreign stocks that many wonder whether foreign stocks have any role in a portfolio.

Over the 10 calendar years ended December 1998, the Wilshire 5000 index of most regularly traded U.S. stocks returned 18.1% a year, while Morgan Stanley's Europe, Australasia and Far East index gained just 5.9% annually, according to Chicago's Ibbotson Associates.

But while U.S. stocks have recently had the upper hand, the long-term records are indistinguishable. Since year-end 1970, the Wilshire 5000 and the EAFE indexes have had exactly the same return, 13.7% a year through December 1998, according to Ibbotson. Indeed, this year, the performance gap has closed somewhat. Through April 30, the Wilshire 5000 was up 8.7%, while EAFE had gained 5.6%.

Mr. Bogle concedes that long-term U.S. and foreign stock returns are similar. What worries him are the risks involved in venturing overseas. He frets about currency swings, which make foreign-stock funds perform so erratically. He also worries about the less-favorable political and legal environment found abroad.

"The U.S. gives a notably high priority to the interests of investors," Mr. Bogle says. "This is a great environment for investing."

Mr. Malkiel's response? He allows that there can be weaker legal protections and less political stability overseas. "There's no doubt you have those risks, especially in emerging markets," he says. "But that's why the returns should be higher" in emerging markets, as investors are rewarded for this extra risk.

Mr. Malkiel also readily concedes that, for U.S. investors, foreign stocks perform more erratically. But, perversely, adding these foreign stocks to a U.S. portfolio can cut your portfolio's risk level.

Because foreign stocks don't move in sync with the U.S. market, they can provide offsetting gains when U.S. stocks are suffering. "You can add a risky investment and reduce your overall portfolio risk," he explains.

Mr. Bogle isn't buying that argument. "What's the point?" he asks. "You're only reducing volatility by a very small amount."

Mr. Malkiel's fondness for foreign stocks isn't just based on long-term arguments. "The short-term argument is a relative valuation argument," Mr. Malkiel says. "The valuations are much more reasonable," especially in Japan and emerging markets.

For proof, he points to what has happened to stock prices relative to book value, which is the per-share difference between corporate assets and liabilities.

"Nine years ago, Japanese stocks were at five and six times book value and the Japanese couldn't do anything wrong," Mr. Malkiel notes. "Now, they're at one or two times book value and we're at five or six times book and we can't do anything wrong. Our stock market is priced for perfection."

Mr. Bogle acknowledges that the American economy's incredible buoyancy could pass. Indeed, in his book, he devotes a whole chapter to reversion to the mean, the notion that highfliers will get beaten down and downtrodden sectors will bounce back. And foreign stocks certainly seem overdue for a rebound.

Yet Mr. Bogle still shies away from foreign stocks. "I believe in reversion to mean, and I think it's likely to happen," says Vanguard's senior chairman. "But I don't know when it will happen. I don't think any of us have the brains to make that sort of market call."

I have a ton of respect for Jack Bogle . In fact, I admire him more than is healthy for any journalist. But on this issue, I believe that not only is his argument wrong, but also that his timing couldn't be worse.

Foreign stocks will come roaring back. Maybe not this year. Maybe not next year. But like small-company stocks, foreign markets will once again shine -- and those who own portfolios heavy with blue-chip U.S. stocks will regret their lack of diversification.


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