risks. This is because these variables are not perfectly correlated, so
movements in the exchange rate and the local stock market frequently
offset each other.
The standard deviation of dollar returns in foreign markets is nearly
22 percent, about 5 percentage points higher than found in the U.S. mar-
ket. The historical correlation between the annual returns in U.S. and
non-U.S. markets has been about 57 percent, which means that 57 percent
of the variation in non-U.S. markets is also seen in U.S. stock returns.
Using these historical data allows us to construct Figure 10-2,
which shows the risk-return trade-off (called the efficient frontier) for dol-
lar-based investors depending on varying the proportions that are in-
vested in foreign markets (measured by the EAFE Index) and U.S.
markets. The minimum risk for this world portfolio occurs when 22.5
percent is allocated to EAFE stocks and thus 77.5 percent to U.S. stocks.
But the “best” risk-return portfolio, called the efficient portfolio, is
not the one with the lowest risk but the one that optimally balances risk
and return. This “best” portfolio is found at a much higher 37.8 percent
foreign stock allocation.^7 For comparison, in July 2007 the EAFE stocks
170 PART 2 Valuation, Style Investing, and Global Markets
FIGURE10–2
Portfolio Allocation between U.S. and EAFE Stocks12.00%12.20%12.40%12.60%12.80%13.00%13.20%13.40%13.60%13.80%16% 17% 18% 19% 20% 21% 22% 23%
RiskReturn100% U.S., 0% EAFE90% U.S., 10% EAFE50% U.S., 50% EAFE80% U.S., 20% EAFE40% U.S., 60% EAFE20% U.S., 80% EAFE30% U.S., 70% EAFE10% U.S., 90% EAFERisk-free rate is 5.0% 0% U.S., 100% EAFE70% U.S., 30% EAFE60% U.S., 40% EAFEU.S. Portfolio
EAFE Portfolio
Minimum Risk
Efficient PortfolioRisk
17.100%
21.928%
16.585%
16.825%Return
12.207%
13.641%
12.529%
12.749%% U.S.
100.0%
0.0%
77.5%
62.2%% EAFE
0.0%
100.0%
22.5%
37.8%