How to boost your expected returns

(MoneyWatch) Today's investors face unusual challenges, as low bond yields and lower expected stock returns mean the returns investors can expect from their portfolios may not be sufficient to meet their goals. Smart investors know that to minimize the risk of their plan failing they must change their plan. Typical options that investors consider to reduce that risk include:

• Lowering the return goal which means lowering your future spending plans
• Curtailing current spending to increase savings
• Extending planned retirement date
• Taking more risk within their bond allocation and/or increasing their stock allocation

The first three options are all prudent ones. However, the last one isn't likely to be a prudent choice. Taking increased risk on the bond side hasn't been historically well rewarded, and 2008 should have taught investors the dangers of having too high a stock allocation. With that said, there's a prudent option to increase the expected return of a portfolio available to most investors -- shift some of the allocation to domestic stocks to international stocks.

• Why active fund management has failed
• Active managers' latest excuse
• How you and your employer botch your 401k

It's unfortunate that most U.S. investors fail to take advantage of the one basically free lunch available to them: Diversification. As I discuss in my book, Investment Mistakes Even Smart Investors Make, like investors all over the world, U.S. investors make the mistake of confusing the familiar with the safe. That leads them to have little to no allocation to international stocks, despite the fact that U.S. stocks now make up less than half the global stock market's capitalization. Let's take a look at the data covering the period 1970-2012:

As you can see, the MSCI EAFE Index has provided similar returns to the S&P 500 Index, with about an 11 percent higher level of volatility. However, a 50/50 portfolio that was rebalanced annually actually produced both higher returns and less volatility.

If you need to generate more expected return and currently have a low allocation to international stocks, increasing your allocation to the stocks of both international developed markets and emerging markets will provide you not only with more diversification of economic and political risks, but also with a higher expected return for your portfolio. Let's see why that is currently the case:

Using data from Morningstar, the following table provides the current valuation metrics for four Vanguard index funds:

• Vanguard 500 Index Fund (VFINX)
• Vanguard European Stock Index Fund (VEURX)
• Vanguard Emerging Markets Stock Index Fund (VEIEX)
• Vanguard Total International Stock Index Fund (VGTSX)

While valuation metrics aren't perfect predictors, they do help explain a significant portion of future returns -- lower valuations predict higher future returns. For example, an October 2012 study by Vanguard found that P/E ratios explain about 40 percent of the time variation of net-of-inflation future returns. As the table below shows, valuation metrics are much higher for the U.S. index fund than in every other instance.

Increasing your allocation to international stocks will increase the expected return of you portfolio, as well as your diversification of economic and political risks. However, the higher expected returns shouldn't be seen as a free lunch. The valuations of international stocks are lower because the markets perceive them as riskier. With that said, increasing your allocation to international stocks is a more prudent way to increase the expected return of the portfolio than increasing your overall exposure to stocks. The latter increases your exposure to global systematic risks, while the former doesn't.

One last word of advice: When going international, think small and emerging markets more than developed large. The correlations of international small and emerging market stocks to U.S. stocks are lower than is the correlation of international developed large stocks and U.S. stocks. Thus, they're superior diversifiers. From 1988 through 2012, the annual correlations to the S&P 500 were:

• MSCI EAFE: 0.74
• MSCI Emerging Markets: 0.53
• Dimensional Fund Advisors International Small Cap Index: 0.58

You should also consider thinking more value than growth. While their correlations to U.S. stocks are similar, as is the case with small stocks, value stocks have higher expected returns, allowing you to hold less overall stock risk to achieve the same expected return for the portfolio. And that provides the benefit of reducing your overall exposure to systemic global risks, reducing your losses during bear markets.

Image courtesy of Flickr user 401(K) 2013.