Diversify by Investing Internationally and Take Advantage of a Weakened Dollar
According to A.G. Edwards' Investment Strategy Committee, foreign investments are becoming a more attractive opportunity for investors right now. "We recommend that investors begin to allocate a little more money to international investments than they did last year," says A.G. Edwards Chief Economist Gary Thayer.
Why Invest Internationally?
"The dollar has weakened since last year," Thayer says. This increases the earnings power of foreign investments. "Last year the dollar was strong and interfered with the return potential of foreign investments," he says. Although the earnings of those investments may have been good, the exchange rate dramatically decreased the investor's actual returns.
"International investing also provides an excellent way to increase the diversification within your portfolio," Thayer says. Diversification is the spreading of investments among different assets classes (stocks, bonds or cash), industries, company sizes, value or growth characteristics of the companies, regions, and countries. By doing so, you can potentially decrease your portfolio's total risk exposure.
Types of Foreign Investing
There are a variety of ways to begin investing internationally:
• Mutual funds, which invest in stocks, bonds or a combination of securities, are an easy and affordable way to add international exposure to a portfolio, taking advantage of professional money management and diversification while overcoming many barriers involved with foreign investing. Among the types of funds you can choose from are global, international, regional, sector, country and emerging-markets funds.
• Money management firms make the day-to-day investment decisions for your portfolio, while individual ownership of the securities remain with the investor. Global money managers focus primarily on foreign investments.
• Foreign closed-end funds are traded on exchanges like stock, so their prices are set by supply and demand, as opposed to a mutual (or open-end) fund, in which shares are bought and sold through the fund company at a price based on the fund's net asset value.
• Defined portfolios are a convenient and cost-effective way to invest in a professionally selected, fixed portfolio of foreign securities for a set term.
• Exchange traded funds (ETFs) are passively managed portfolios designed to track the performance of a certain stock market index or a basket of stocks representing an industry, investment style, company size or a variety of other characteristics. ETFs can be traded like stocks. To take advantage of foreign investing, you would choose an ETF with a focus on foreign investments.
• U.S.-based multinational corporations derive a substantial portion of their revenues and profits from foreign markets, usually maintain offices in other countries, and are frequently traded on foreign exchanges. U.S.-based multinational corporations provide several advantages associated with foreign investing: trading is easy, information is readily available, and interest or dividends are paid in U.S. dollars.
• American depositary receipts (ADRs) are foreign stock receipts issued by a U.S. bank and based on the stocks of an overseas company. ADRs avoid many of the complications associated with purchasing shares on foreign exchanges.
• Individual foreign securities are bought and sold on foreign exchanges and, in some cases, directly from the company. Many countries allow noncitizens to directly invest in their equity and bond markets, but some countries prohibit or limit such investing. Potential problems involved with foreign investing include varied trading and accounting rules, slow trade clearings, complication of trade orders due to language and timing barriers, changes in currency values and currency exchange fees, and varied foreign tax rules.
Risks of Foreign Investing
In addition to the general risks associated with stocks, there are special considerations related to foreign investing. Because the world's economies and stock markets move in different cycles, investment opportunities shift from country to country. An investment portfolio with broad global diversification has the potential to limit exposure to poor-performing markets while gaining exposure to strong-performing ones. Of course, a decline in the value of investments in one country may offset potential gains from investments in another country.
There are risks to investing internationally, and you shouldn't let your money travel abroad without understanding what those risks are. Risks include:
• Market risk. The risk of general market pressures causing the fluctuation of an investment's value.
• Foreign security risk. The potential volatility of foreign stocks, or the potential default of foreign government bonds, due to political and/or financial events in that country.
• Currency risk. With many foreign investments, currency must be converted to or from U.S. dollars to complete transactions. Once the U.S.-dollar investment is converted into a foreign currency, you are exposed to fluctuations in the currency exchange rate. The exchange rate defines how many U.S. dollars you receive for a unit of the foreign currency and vice versa.
• Nondiversification risk. Concentrating your investments in one area of the world, asset class, sector or company size can increase your portfolio's risk exposure. Diversifying can help decrease your portfolio's risk.
• Political and social instability. World events and economic conditions abroad can take sudden dramatic turns. Recessions, inflation, unemployment, information gaps and political climates on international fronts often create apprehension for any investor considering a global approach.
• Accounting and reporting differences. Accounting and reporting procedures, as well as regulatory environments, differ among foreign companies and foreign markets. Any comparative earnings analysis involving a foreign company has to take into consideration variations of accounting standards around the world.
• Foreign tax treatment. Some countries automatically withhold tax from dividends paid to foreign investors, such as U.S. citizens. Of course, if you're a U.S. citizen, the IRS taxes your investment income, including any foreign income. The interplay of foreign and U.S. tax regulations can create confusion. Many U.S. investors are surprised to discover that dividend income from their foreign investments can be 15% to 35% short of expectations.
Investing abroad presents certain risks as well as potential for profits. It also has the benefit of making your investment mix more diversified. Discuss your objectives with your financial consultant. He or she can help you determine whether global investing is right for you and select investments that are appropriate for your needs.