Stocks for the Long Run : the Definitive Guide to Financial Market Returns and Long-term Investment Strategies

expected return in each country and the expected correlation between

returns of the U.S. market and these emerging countries. One way of es-

timating these expected returns, risks, and correlations is by analyzing

the historical return data. Once these expectations have been deter-

mined, the “best” or most “efficient” risk-return portfolio can be deter-

mined by mathematical techniques of formal portfolio analysis.

The historical risks and returns for U.S. and foreign markets are

shown in Table 10-2. One can see that from 1970 through 2006, the dollar

returns on Morgan Stanley’s EAFE Index, an index of the developed

world stocks,^6 actually surpassed that of the United States, offering dol-

lar-based investors compound annual returns of 11.57 versus 10.84 per-

cent in U.S. stocks.

Although the return was higher in foreign stocks, the risk was also

higher. The risk of these returns to dollar investors in foreign markets is

composed of two sources: fluctuations in foreign stock markets them-

selves, called local risk, and fluctuations in the exchange rate that trans-

lates foreign returns back to dollars, or exchange-rate risk.

It is very important to note that the total risk of holding foreign eq-

uities is substantially less than the sum of the local and exchange-rate

CHAPTER 10 Global Investing and the Rise of China, India, and the Emerging Markets 169

TABLE 10–2

Dollar Returns and Risks in Stocks, January 1970 through December 2006

Compound Arithmetic

*Correlation between U.S. dollar returns and foreign market U.S. dollar returns.

Japan 11.47% 16.05% 28.34% 12.71% 34.69% 29.90%

Europe 12.27% 14.10% 20.18% 11.27% 20.95% 70.57%

USA 10.84% 12.21% 17.10% —— 17.10% 100.00%

EAFE 11.57% 13.64% 19.30% 10.25% 21.93% 57.42%

World 10.81% 12.17% 16.57% 5.07% 17.07% 84.27%

Country or

Region

U.S. $ Returns Domestic

Risk

Exchange

Risk Total Risk

Correlation

Coefficient*

(^6) The countries in the EAFE portfolio are Australia, Austria, Belgium, Denmark, Finland, France,
Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Por-
tugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.