The cornerstone of any great investment portfolio is diversification. It’s how the investor safeguards their investments from unforeseen risk and maximizes their potential for returns. This is because major economic events are often impossible to predict. As a result, they can severely cripple a portfolio that has too much in one place. So, what’s the best way to maintain a diversified portfolio? We’ve spoken before about the importance of asset allocation and making sure your investments span multiple types. It’s also wise to think bigger. And so, should this include investing in foreign equities?
Participating in the global economy is an excellent way to give your portfolio an extra boost. It’s never been easier to invest in foreign stock, and it’s a move that can provide big long-term gains.
Investing in foreign equities markets may seem daunting at first. However, this doesn’t mean you shouldn’t at least consider it. In this post, we’ll highlight some of the best ways to get your investment portfolio to an international level. And get an idea of the best way to maximize your returns and minimize the risk in your portfolio.
Benefits of Foreign Equities Investing
We’ve mentioned that investing in foreign markets will improve the diversity of your investment portfolio. But is it necessary? It may be tempting to only focus on diversifying your domestic assets sufficiently. This is certainly a good idea, and may be all you need to do. Investing internationally, however, has its own unique benefits.
There’s a level of geopolitical risk tied to having all of your assets in one country or region that foreign investing alleviates.
It’s also true that economic performance tends to be cyclical. And this is true everywhere in the world. Investments in different markets will make it much more likely that at least part of your portfolio is always performing well. While the U.S. was underperforming in the 2000s, for example, many emerging markets were performing very well. Those with investments in these markets were able to recoup some of their losses in U.S. investments even while the domestic economy was struggling.
Emerging markets afford additional investment opportunities for those willing to look outside the U.S. The potential for growth with these rapidly growing markets is often sky-high. Of course, it’s important to thoroughly research these types of investments. As always, higher return potential is almost always tied to higher risk.
Risks of Foreign Investing
While there are plenty of upsides to getting involved in foreign investment, it isn’t without its own pitfalls. These are worth examining because the whole idea behind diversifying your portfolio is mitigating big risk, right? Knowledge is key here. And understanding the risks will help you prepare for them and hopefully avoid them.
Foreign investments are generally riskier than investments in your home country. Many foreign markets have less regulation than the United States stock exchanges. And this makes them more susceptible to fraud or manipulation. Other risks include political destabilization and regionally-specific natural disasters.
Another thing to consider is currency risk. Dealing with foreign currency means that changes in the exchange rate can potentially have a dramatic impact on the value of your investments.
For example, let’s say you have an investment in an Australian company in Australian Dollars. If your investment performs well and you see 8% growth, you can still lose money on your investment if the Australian Dollar happens to drop over the period of your investment. Of course, if timed well, these changes can also be positive.
Risk is an inherent part of investing. The risks that are specific to investments in foreign markets are real, but you can minimize them with smart investing. More aggressive investors may recommend allocating up to 20 or even 40% of your portfolio to foreign investments. However, limiting yourself to 10-15% will be more effective at mitigating the risks.
How to Invest in Foreign Equities Markets
There are several different methods for investing in foreign markets, and we’ll go over three of the most common in this post. Fortunately, you’ll see that there are straightforward ways to get involved internationally without having to do a couple of things. As such, you wouldn’t have to work with other currencies or handpick stocks in unfamiliar markets if you don’t want to.
American Depository Receipts (ADRs)
One of the more straightforward ways to buy foreign stocks is through the use of ADRs. These are foreign securities that are traded in the U.S. — they are in U.S. dollars. ADRs are receipts of international stocks that U.S. banks have purchased.
Purchasing ADRs is a convenient way to buy foreign stocks because the shares act just like any other. The fact that the trades happen using U.S. dollars is another benefit. One thing to note, however, is that while dividends are paid out in USD, they are still subject to foreign tax withholding.
It’s also worth mentioning that there is an ADR fee to account for with these types of investments. This is a fee set by the custodian bank of the ADR, as this would offset the administrative fees that come with setting up the ADR. The fee is calculated at the time of the dividend payment for dividend-paying ADRs.
Foreign Mutual Funds
Another convenient option for investors who’d like to invest globally is the purchase of mutual funds. International mutual funds operate in exactly the same way as those that are domestic. But they are comprised of a portfolio of international stocks.
The variety of mutual funds available is huge. There are mutual funds that focus on specific geographic locations and industries. And they even come in a range of risk-levels, from very conservative to very aggressive. You can also choose between mutual funds that focus on different market caps, from small to large.
For example, do you have interest in emerging markets, other developed countries, or a mix?
All this variety is a good thing. So with a little bit of looking, you should be able to find the right mutual fund for your portfolio.
Exchange-Traded Funds (ETFs)
ETFs are similar to mutual funds in that the investor is has no need to choose individual stocks to purchase. Foreign stocks are what make up these ETFs. And these ETF stocks focus on things like country, investment style, or market capitalization.
Since many ETFs are so unique from each other, it can be a good idea to invest in several. This can give your portfolio an extra layer of diversification in the global marketplace.
There are some special considerations one should make when investing internationally. While ADRs, mutual funds and ETFs make the process fairly straightforward for U.S. investors, it’s important to look closely.
International Index Funds and Market Capitalization
Market capitalization is the value of all of the shares in a company, and it often influences the composition of index funds. Both international and domestic index funds are either weighted by market cap or equally. Funds that are weighted by market cap put more money into the companies with the highest market cap.
If you’re investing internationally in order to achieve more geopolitical or regional diversity in your portfolio, this is something you’ll want to look out for. Investing in an international index fund might mean investing a much higher percentage into one country than you realize.
Both strategies are viable, but it’s a good idea to consider which method suits your portfolio. This is something a skilled wealth manager can help you with.
There are additional costs associated with investing internationally. It’s generally more expensive than investing domestically. This is something to be aware of, but it shouldn’t scare you away from doing any foreign investing; the rewards outweigh the additional expense.
When considering any new trade, be sure to clarify the following costs with your broker:
Currency conversions (if necessary)
Foreign taxes on dividends from non-U.S. investments
Total transaction costs, including broker fees and expense ratios
Final Thoughts for Foreign Equities and Investing
In many ways, the world is getting smaller every day. This doesn’t mean that economies in different regions are performing at the same rate, however. At any given time, there are areas experiencing economic turmoil and there are those experiencing growth and showing opportunity for further growth.
Globalization is making it easier than ever to interact with a variety of economies all around the world. In fact, you can simply purchase international stocks through stock exchanges in the U.S.
Sure, there are unique risks and costs with investing in foreign equities, but they also offer unique advantages. This is no different from any type of investing. Taking the time to research your options carefully and consulting professionals you can trust is part of creating and maintaining a solid investment portfolio of any kind.
Don’t neglect the international investing options available to you. They offer an effective path to greater diversification and can protect your wealth from some of the volatility that’s inherent in the stock market.
At Saddock Wealth, we bring years of wealth management experience to the table and can guide you toward financial prosperity. Make sure your wealth is in the right hands and ready to grow in 2020.