Should You Invest in Foreign Countries?
Foreign investments add diversity but there are risks
Investing in foreign countries is a relatively new option for individual investors. Luckily, the advent of internationally focused mutual funds and exchange-traded funds (ETFs) has made it easier than ever. But, is investing abroad a good decision? As always, the decision to invest in foreign countries depends largely on your investment objectives, but this article will take a look at some of the pros and cons.
Why Invest in Foreign Countries?
The primary rule of investing is to seek the highest risk-adjusted return for their capital (also called "alpha"). Basically, you want to maximize profit made beyond the amount of risk taken in any given investment. One of the best ways to accomplish this is through diversification, which has been mathematically proven to enhance risk-adjusted returns.
An effectively diversified portfolio holds at least 8-10 uncorrelated assets (or, assets that do not move in relation to each other) spread across various industries and geographies, which ensures that an adverse event in one market will not negatively affect the entire portfolio. As a result, investing in foreign countries (geographical diversification) is an important way to enhance risk-adjusted returns through diversification.
For example, the Vanguard MSCI EAFE ETF (NYSE: EFA) has a 0.78 correlation with the S&P 500 SPDR ETF (NYSE: SPY), while the iShares MSCI Emerging Markets Index ETF (NYSE: EEM) has just a 0.69 correlation, according to 6-month data from ETFScreen.com ended January 9, 2017. Many domestic stocks and funds have a much higher correlation that reduces diversification.
Where Do Foreign Investments Fit?
The U.S. is known worldwide for its safe-haven investments, like Treasury bonds and blue-chip companies. Likewise, foreign countries often fit into their own categories of investments, ranging from commodities to growth stocks. As a result, investors seeking these types of investments may want to look at using foreign stocks to fill the void to enhance diversification.
Foreign countries in the so-called BRIC (Brazil, Russia, India and China) group are primarily known for their growth opportunities. These countries have experienced significant levels of economic growth, which has helped many companies within prosper. However, as with any developing nation, there are increased risks associated with the ability to successfully manage growth long-term.
Other countries are known for their specific areas of focus. For example, Nigeria is known for its risky offshore oil industry; Chile is famous for its rare minerals; Canada is known for its gold and oil sands; the Middle East is popular for its oil and gas opportunities. Each foreign country has its own areas of economic focus and risk-to-reward profile for international investors.
The Key Risks of Investing Abroad
There are risks to investing in any country or market - including the United States - which is why creating a diversified portfolio is so important. For example, if the U.S. made a mistake in monetary policy and the dollar spiraled downward, wouldn't it be nice to be invested in other countries that aren't affected? However, there are several risks specifically associated with foreign versus domestic investing.
Here are three of the most significant risks:
- Currency Exchange Rate Risk: Foreign companies often generate sales and income in their local currency - such as euros or Swiss francs. As a result, investors from the U.S. must convert these currencies into U.S. dollars at some point. Unfortunately, the exchange rate between currencies fluctuates over time and can lead to unexpected gains or losses.
- Geopolitical Political Risk: Some foreign companies operate in countries that may face geopolitical risks, such as terrorism or potentially hostile neighbors. For example, South Korea faces the risk of an attack by North Korea. As a result, investors should carefully consider the risks associated with the countries in which they invest.
- Economic and Credit Risk: Foreign companies are often dependent on the health of their host country's economy. While the U.S. has an AAA credit rating, there are many countries that have investment ratings ranging from near-perfect to well-below investment grade. And, adverse economic events in these countries could impact companies operating within.
Key Takeaway Points
- International investing is a relatively new possibility for individual investors, with the rise of mutual funds and ETFs focused on global opportunities.
- Choosing the right international investment destinations depends largely on an individual investor's needs and where they'd like to target their capital.
- There are many risks associated with international investing, including currency risks, geopolitical risks, and credit risks, among others.