So far, these posts have focused largely on American investments and institutions. But overseas investing offers opportunities that are frequently well worth the risk, although not for everyone.
Why Go Abroad?
At least half the world’s stocks and bonds are issued outside the U.S. These offer different opportunities than those in the U.S., and when it comes to diversification, they have unbeatable advantages. Three points make the case:
- Because foreign economies frequently show strength when the U.S. economy shows weakness, investment positions abroad offer diversification that can give your portfolio buoyancy even when U.S. business hits one of its recurring rough patches. Foreign investing, in other words, offers other baskets for your investment eggs.
Note: Though many American firms have considerable overseas exposure, they are not a substitute for holding foreign bonds and stocks. The stocks of American firms, even those that earn more revenues abroad than at home, such as Coca-Cola, Proctor and Gamble, and Exxon Mobil, still respond mainly to conditions in the U.S.
- Often, overseas investments offer the only effective means to gain exposure in certain industries. If, for instance, you wanted to buy the stock of a large, global engineering firm for your portfolio, you would have to go overseas. There are publiclly traded engineering firms based in the United States, but only a few do much overseas business and most of those that do are privately owned.
- Investing in foreign instruments is sometimes the only way to capture the main competition to American firms. Boeing, for instance, has as its chief competition the European consortium, Airbus. When one of them bests the other for a big contract — say from China Airlines — the loser’s stock drops while the winner’s rises. Having exposure to both companies eases concerns over which firm will win the next contact and focuses your investments on the far more secure prospect that the world’s airlines will both grow and upgrade their fleets.
What Are Your Options?
Investment professionals classify foreign stocks and bonds into three basic groups:
- Developed Europe: This includes the United Kingdom, France, Germany, Scandinavia, Italy, Spain, etc. These economies, because they do a lot of trading with each other, frequently move in concert. Generally, European countries that have relatively recently emerged from communist rule –– Poland, Hungary, the Czech Republic, and others –– are classified as emerging markets.
- Developed Asia: Here the classifiers face real ambiguity. Japan, of course, counts as a developed market. South Korea, Hong Kong, Taiwan, and Singapore have many well-established financial and economic structures, such as a developed market economy, but many analysts still view them as “emerging,” if well along the way to full development. China, too, is sometimes included in this group, as is India. What is more, these Asian economies, fully developed or not, depend less on each other than do their European counterparts and thus move less in concert than does developed Europe.
- Emerging Markets: These include a diverse group, ranging from just about all of Latin America to, among others, Vietnam and Indonesia in Asia; Kuwait, Abu Dhabi, and others in the Middle East; Egypt, Nigeria, and South Africa in Africa, though some consider South Africa as developed. Some analysts make distinctions within this category, referring to the better-established members as emerging and less established members as frontier markets.
- You may think it strange that the classification system makes geographic distinctions for developed markets but not for emerging markets. Certainly, some emerging economies have clear geographic biases. Latin America, for instance, has a particular orientation toward the United States, while the ex-communist countries in Europe share an orientation toward Western Europe. Some professionals make geographic distinctions on the basis of such orientations. But two critical aspects common to all emerging markets override such geographic distinctions:
1. They are all at an early stage of development, giving each of them the potential for more rapid growth than developed markets.
2. All emerging markets depend for growth and profitability on the developed world’s demand for their products and its willingness to invest in them directly. As a consequence, all emerging markets, regardless of their location, are subject, often in exaggerated ways, to the positive and negative shifts in the developed economies.
This is probably the biggest single risk in foreign investing. Because stocks and bonds bought abroad are almost always denominated in currencies other than the U.S. dollar, an American investor can lose (or gain) simply from fluctuations in currencies. Take, for example, investments in Germany, where stocks and most bonds are denominated in euros. Should the euro lose value against the U.S. dollar, your euro-dominated investments, even if they rose sharply, would be worth less in dollars. Conversely, were the euro to gain against the dollar, those investments would gain dollar value even if they otherwise performed badly. The same risk and potential applies to almost all foreign investments.
For some, this risk is reason enough to avoid foreign investing, and that is understandable: Currency values can swing wildly from one month or year to the next, and they can do so in seemingly unpredictable ways. However, before giving in to such fears consider these facts:
- Investors can hedge currency risk. (More on this in a coming post.)
- Currency moves can sometimes cut two ways. Take the earlier example of German investments. If the euro were to fall against the dollar, it is true that the dollar value of euro-dominated investments would fall with it. But at the same time, a drop in the euro would also give German exports an advantage on global markets by reducing their price in terms of other currencies. This boost to German business prospects might well raise German stocks sufficiently to offset much or all of the loss due to currency shifts.
- A purely domestic portfolio hardly avoids currency risk. To understand why, move the German example just given to the United States. If the dollar were to rise against the world’s currencies, the holder of a purely domestic portfolio might be pleased for having avoided the currency loss implicit in foreign investments. But that same investor might face a setback because the rising dollar means an increase in the global price of American products and so puts American producers at a competitive disadvantage. The currency move would also make foreign imports cheaper in the United States and thus put even purely domestic American producers at a competitive disadvantage.
How Much Is Enough?
Some business school academics have said that because half the world’s assets lie outside the U.S., half your assets should, too. This would be a mistake. As with so much else in investing, the right answer depends on your individual circumstances and plans. Are you investing in order to buy a home in a few years? That relatively short time horizon might preclude you from taking the risk of overseas investments. But if you are investing for a retirement that is decades into the future, price volatility would present less of a problem compared to the investment’s long-term potential. Your decision would also hinge on where you want to retire. If you are thinking of Bali, or Paris, you may want more of your portfolio in those respective markets than if you plan on living your retirement years in Utica, NY.
Because most readers contemplate their future liabilities in dollars, and because of the other risks of investing abroad, few should even consider putting half their wealth overseas. Generally, the longer time you have before you need the money, the more risk you can afford to take advantage of overseas investment opportunities, and so the more you will place abroad. As I have said, in the end it will come down to your personal tradeoff between the risks you are willing to take, your circumstances, and your goals. This is something you may well want to discuss with your broker or financial advisor.
How to Do It
It is no more difficult to invest abroad than in the United States. Full service brokers can recommend investments and also buy and sell foreign securities for you. They will report to you with values stated in the currencies of those countries and also in dollars, using a recent exchange rate. You can also open a brokerage account overseas. None of this is very complex––though tax reporting can become cumbersome. Many foreign companies also are listed on U.S. exchanges in what are called American Drawing Rights (ADRs) or Global Drawing Rights (GDRs). These actually quote the stock in dollars and give the appearance of trading just like U.S.-based companies. A box below lists just a few of the many foreign companies trading this way.
Note: Because these ADRs and GDRs quote prices in dollars and seem to trade just like U.S. companies, many investors mistakenly believe that such trades avoid currency risk. But be aware that their American listing simply converts the price quoted in their currency of origin into dollars at a recent exchange rate. If the dollar’s foreign exchange value rises (or falls), the dollar quote of an ADR or GDR listing will fall (or rise) just as if you held the asset in the foreign country.
Because it is more difficult to obtain research on foreign companies and keep up with overseas events, it is usually wise to delegate the management of these investments to professionals. Mutual funds can serve this purpose. You can buy into a number of no-load mutual funds with a focus on foreign stocks, just as with domestic investing. Brokers will not buy you these funds, because they make no commission on the purchase, but they can buy you other mutual funds (of the load variety) and ETFs that specialize in foreign stocks. Some mutual funds, either the load or no-load variety, tout their security-picking abilities. As with domestic investing, make sure that you have done a complete review of these funds’ performance record to see if they’re worth their fees. The marketplace has any number of mutual funds that make no pretense of such abilities, and for a relatively low fee, they will invest your finds in a broad index of stocks in a specific market or region.