Reduce Investment Risk with Stock Diversification

Does International Investing Still Make Sense?

Much has been written recently about whether it makes sense to invest in international markets. Some investors question the benefit of international diversification because economic globalization has caused markets to move more closely together, the world’s economies are becoming more interrelated, and dramatic changes in stock value in one market can spread quickly to other markets. Yes, the correlation between markets has increased, but you can still reduce your portfolio’s volatility by adding some international equities to your portfolio and potentially enhance overall performance. If diversification has you adding bonds to your stock holdings and small-cap stocks to a large-cap stock portfolio, including overseas stocks derives the same benefit.

Stock market volatility is a major reason for investing globally. All countries go through economic cycles but not at the same time. Investing in different markets reduces the impact when one region experiences a downturn. For example, Japan, had a great year in 1999, but has also produced some of the worst returns over the last 10 years. You don’t know which markets will outperform, which ones will stink, that’s why diversification is so important. Ignore the thousands of other possible global stock investments and you miss out on some excellent opportunities for growth and performance.

Some interesting facts
Companies outside the United States now represent more than half of the world’s total market value.
There are more than twice as many foreign companies (19,658) as U.S. companies (8,251) in which to invest.
Many of today’s leading multinational companies are based outside the U.S. (i.e., Nestl, Toyota, and Hong Kong Shanghai Bank).
Between 1970 and 2000, the U.S. equity market has never been the world’s top performer and has ranked among the top 3 only twice in the last 10 years.
The world’s largest food company is not a U.S. company (Nestle SA-Switzerland).
Burger King, Breyers Ice Cream, Dunkin Donuts, and Dannon Yogurt are all foreign based companies (U.K., Netherlands, U.K., France, respectively).
The leading mobile phone operator in the world is Vodaphone Airtouch Plc (U.K.)

There are additional risks to investing in international markets. Some of these risks are:

Political risk addresses the stability of the government, the actions of the government, and the stability of the political climate. Governments can change, take over companies, and can drastically change policies and rules.

Currency risk is concerned with the value of the stocks local currency as compared to the U.S. dollar. Foreign companies trade and pay dividends in the currency of their local market. When you receive dividends or sell your international investment, it’s converted into U.S. dollars. Depending on the exchange rate, it can translate into more or fewer dollars.

Market risk concerns the reliability of reported corporate information and the ease (or lack of) of trading shares. Accounting practices may differ making comparisons difficult. For the U.S. based investor, the marketplace has several options to invest internationally.

Mutual Funds – International investing through mutual funds can reduce some of the risks.
More diversification than most investors could achieve on their own.
Professional management – Because international markets are have additional risks, mutual funds can add value because the fund manager is familiar with international markets and has the resources to research.
Mutual funds will handle currency conversions and pay any foreign taxes.

Mutual funds that invest internationally probably will have higher costs than funds that invest only in U.S. stocks.
Investment style risk – although the funds prospectus mandates the percentages & limits of where and what to invest in, the latitude can still allow for some wide variances in style and strategy.

There are different kinds of mutual funds that invest in foreign stocks.
Global funds invest primarily in foreign companies and developed markets but may also invest in U.S. companies.
International funds generally limit their investments to companies outside the United States with a variety of stocks from many countries. Because they’re more broadly diversified, global and international funds may be less volatile than emerging market or single country funds.
Regional or country funds invest principally in companies located in a particular geographic region or in a single country. This provides a way to focus on political or economic conditions that may be favorable. However, they are more volatile since they’re less diversified than international or global funds.
Emerging market funds – These funds generally invest in developing markets (i.e., Russia, South Korea, Mexico) and many are in transition from government control to a free market, or from agricultural to industrial. They are often very volatile, but can sometimes offer the potential for great returns. They also tend to have the lowest levels of correlation with American stocks, which gives you the most effective diversification.
International Bond Funds – International bond funds primarily invest in debt securities issued by foreign governments and corporations.

ADR’s (American Depository Receipts)
An ADR is a registered security issued by a U.S. bank representing shares of a foreign stock. ADR’s trade on U.S. stock exchanges and on the over the counter market. Companies traded through ADR’s must comply with U.S. General Accounting Practices. If you own an ADR, you have the right to obtain the foreign stock it represents, but U.S. investors usually find it more convenient to own the ADR. The price of an ADR corresponds to the price of the foreign stock in its home market, with some adjustments.

Advantages compared to owning foreign shares directly:
When you buy and sell ADRs you are trading in the U.S. market. Your trade will clear and settle in U.S. dollars.
The depositary bank will convert any dividends or other cash payments into U.S. dollars before sending them to you.
The depositary bank may arrange to vote your shares for you as you instruct.

It may take a long time for you to receive information from the company (such as shareholder meetings and voting) because it must pass through an extra pair of hands.
Depositary banks charge fees for their services such as for converting foreign currency into U.S. dollars, and usually will pass those expenses on to you.

IShares are index funds that trade like stocks. Shares are available for both U.S. and international equity indexes. The key difference between IShares and mutual fund index funds is that mutual fund trades are executed at the end of the day (market close). IShares trade throughout the day whenever the market is open. Stop and limit orders can also be used.

U.S.-Traded Foreign Stocks.
Although most foreign stocks trade in the U.S. markets as ADRs, some foreign stocks trade here in the same form as in their local market. International investing can be more expensive than investing in U.S. companies. In smaller markets, you may have to pay a premium to purchase shares of popular companies. In some countries there may be unexpected taxes. Transaction costs such as fees, broker’s commissions, and taxes often are higher than in U.S. markets. Mutual funds that invest abroad often have higher fees and expenses than funds that invest in U.S. stocks, in part because of the extra expense of trading in foreign markets.

Two reasons why you should invest internationally are:
Diversification – spreading your investment risk among foreign companies and markets that are different than the U.S. economy, and
Growth – taking advantage of the potential for growth in some foreign economies, particularly in emerging markets.

If you do decide to invest internationally:

Use dollar cost averaging – Investing a set amount of money at regular intervals reduces the risk of buying shares at a market high while ensuring that you will buy additional shares when the price dips.

Seek a mix of fund – Diversify by selecting a variety of investment styles and geographic regions.

Avoid chasing hot areas – Markets go in and out of vogue. By the time you read or hear about a hot region, it may be about to cool off.

Know what you own – Even if you have only invested in U.S. companies, you already may have some international exposure in your portfolio. Don’t duplicate this.

Think long-term – Short-term volatility dissipates with time.
Minimize costs – Select mutual funds whose operational costs are equal to or less than the average for similar international mutual funds.

Go with experience – Select managers of mutual funds who have a proven track record with the same fund (at least three years) and the fund’s performance is equal or better than its peers.