Global Investment Risk
Important Global Risk Factors to Consider
Global investing has become increasingly important as American companies account for a smaller and smaller portion of global revenue and profit. According to Vanguard, U.S. equities accounted for just 49 percent of global market capitalization, but U.S. investors only allocated about 27 percent of their portfolios to non-U.S. funds. The leading mutual fund providers recommend at least a 20 percent allocation to non-U.S. stocks with an upper limited based on global market cap.
In this article, we will look at the risks associated with global investments and whether the benefits outweigh those risks.
What Is Global Investment Risk?
Global investment risk is a broad term encompassing many different types of international risk factors, including currency risks, political risks, and interest rate risks. International investors should carefully consider these risk factors before investing in global stocks.
The three major global investment risks include:
- Currency Risk is the risk associated with fluctuations in a foreign currency relative to the U.S. dollar. For example, a foreign company may report 25 percent earnings growth, but if its local currency depreciates by 10 percent relative to the U.S. dollar, the real growth rate is just 15 percent when the profits are converted back into U.S. dollars.
- Political Risk is the risk associated with foreign governments and politics. For example, Brazil nationalized part of its largest oil company — Petroleo Brasiliero — in a move that caused many investors to lose money. A subsequent corruption scandal involving the company pushed shares even lower.
- Interest Rate Risk is the risk of unfavorable changes to monetary policy. For instance, an emerging market economy may decide that its growing too quickly and act to contain inflation by hiking interest rates. These dynamics could have a negative impact on the value of financial assets that are priced based upon those interest rates.
The best way to mitigate global investment risk is through diversified global portfolios. For example, the all-world ex-US funds provide exposure to a variety of different countries and asset classes around the world, which mitigates the risks associated with any individual country.
Measuring Global Investment Risk
There are many different ways to quantify global investment risk, including both quantitative and qualitative measures. International investors should consider a combination of these approaches when evaluating global investment risk.
The most common quantitative risk measurements include:
- Beta measures an investment’s volatility compared to a benchmark index. For example, U.S. investors may measure the volatility of foreign stocks by comparing it to the S&P 500 benchmark index via a beta coefficient. Higher betas represent more volatility.
- The Sharpe Ratio measures the risk-adjusted return of a fund over time. The ratio is calculated by dividing a fund’s average return minus the risk-free rate of return by the standard deviation. Higher Sharpe Ratios present a better risk-adjusted return.
Global investment risk may also be qualitatively assessed using methods like:
- Credit Ratings provide insights into a country’s credit quality. For example, a country that has a low credit rating may not have the flexibility needed to spark growth, which could lead to a decline in equity valuations.
- Analyst Ratings may provide specific insights into individual international equities. Often times, these ratings include price targets and other factors to consider, although sell-side analyst ratings should be taken with a grain of salt.
Investors should consider how these factors play into their portfolios. Retirement portfolios may want to stick to less volatile stocks, while younger investors may want to consider adding volatility since they may provide greater long-term return potential.
Is Global Investing Worth the Risk?
Global diversification helps lower average portfolio volatility over the long-term. In the short-term, investors can also participate in whichever regional market is outperforming. The U.S. may lead the world during some periods, but there are invariably other periods when another country or market will post the best returns. For example, exposure to diversified non-U.S. equities during the mid-1980s would have outperformed domestic-only portfolios.
Currency movements may also help enhance diversification, since they aren’t correlated with equity performance. Lower correlation with U.S. equities means that investors may have more even returns over time. According to Vanguard, currency movements also increased the volatility of non-U.S. equities by about 2.7% between 1970 and 2013 and the fund provider expects currency to continue to be a key diversifier in the future.
The Bottom Line
Global investing has become increasingly necessary over time, but investors should carefully consider global investment risks. The good news is that there are many different tools available to measure these risks and ensure the right mix for any portfolio. Vanguard recommends allocating at least 20 percent of a portfolio to international investments or potentially more depending on market capitalization changes over time.