International Stocks – Do You Really Need International Stocks?
When you go to a restaurant, do you expect to be able to order from the full menu, or would you settle for picking from only one section of it? If you don’t invest in foreign stocks alongside companies from the United States, it’s as if you are settling for a limited menu.
In fact, with foreign stocks representing more than half of the value of the world’s stock markets, limiting yourself to US stocks would be like choosing from less than half the menu.
These days, investing in international stocks can be nearly as easy as buying domestic stocks. This article will cover some of the basics to get you started.
- What you should know about foreign stock markets
- Why international investing is important
- Risks of foreign investing
- How to buy foreign stocks
Introduction to Foreign Stock Markets
IN THIS ARTICLE
- Introduction to Foreign Stock Markets
- Examples of Top International Stocks
- Why Invest in International Stocks?
- International Index Funds vs. Individual Stocks
- Risks of International Equities
- What Percentage of My Portfolio Should Be in International Stocks?
- How to Invest in Stocks from Other Countries
The New York Stock Exchange and the Nasdaq Stock Market are both based in the U.S. They are the two largest stock markets in the world. So why look elsewhere for investment opportunities?
Well, first of all while those are huge stock markets, there are plenty of opportunities elsewhere. As a matter of fact, while the U.S. market of publicly traded stocks is the most valuable in the world, according to Nasdaq it represents less than half the world’s total.
In other words, if you invest only in U.S. stocks, you are limiting yourself to less than half the opportunities available.
Also, non-U.S. stocks are becoming more important as time goes by. They grew as a percentage of the total world market from roughly 50% in 2000 to 57% in 2018.
If you live and work in the United States, then your finances are primarily dependent on the domestic economy. Having a few investments outside of that economy can be a good way to diversify by making your finances a little less dependent on what’s happening in the U.S.
Examples of Top International Stocks
Investing in foreign stocks should not seem all that strange. After all, you probably already own plenty of foreign products. Why not invest in the companies that make those products?
Look around your house. If you eat Nestle chocolates, own a Samsung phone, have a Toyota in your garage or wear cosmetics by L’Oreal, you’re already familiar with goods produced by foreign companies. Each of those companies is based outside of the United States and is one of the world’s 100 largest publicly traded companies, according to accounting firm PwC.
The line between foreign and domestic goods is not always so obvious. Budweiser beer may be brewed in the U.S., but it’s owned by a company based in Belgium.
The United States cannot even claim the world’s largest publicly traded company. According to PwC, that would be the Saudi Arabian Oil Company, worth over $1.7 trillion.
As with U.S. companies, the best international stocks to invest in are not necessarily the biggest. Beyond these big, prominent names, there are also plenty of other investment opportunities available on foreign markets.
Why Invest in International Stocks?
As the examples mentioned above show, you would be missing out on some of the world’s leading companies if you don’t invest in international stocks. Beyond those specific examples, there are two big reasons to invest internationally:
While there are thousands of stocks available for investment here in the U.S., diversification is about more than just the number of things you own. True diversification means investing in things that perform differently and are exposed to different risks. Owning both U.S. and foreign stocks can help you achieve this kind of diversification.
The U.S. has the world’s largest stock market and economy, but some other countries are growing more rapidly. This means that there are great opportunities in both specific, non-U.S. companies and in foreign markets as a whole.
International Index Funds vs. Individual Stocks
International investing is similar to investing in the U.S. in that you can either pick specific stocks that you think will do well or invest in a market as a whole via an index fund.
An index fund is a mutual fund made up of the same securities that are in a market index. For example, in the U.S., there are index funds designed to represent the S&P 500 and the Nasdaq Composite.
On the international front, you can choose between global indexes that include all markets including the U.S., or non-U.S. indexes. A non-U.S. index may be a good fit in a portfolio that already has a lot of U.S. stock exposure.
Beyond investing in world markets generally, you could also choose country funds based on the market indexes of individual foreign countries.
Instead of indexing, you may want to target specific foreign companies. For most investors, this may limit you to foreign companies that are listed on U.S. exchanges. Many of the largest, most prominent foreign companies are available for investment in this way.
If a company is not listed on a U.S. exchange, you can buy it directly on a foreign exchange. However, this involves foreign custody arrangements that are beyond the means of most investors.
All in all, between international index funds and U.S.-listed stocks of foreign companies, there are ample opportunities for American investors to own non-U.S. stocks.
Risks of International Equities
While international stocks broaden the field of investment opportunities, they also carry additional risks.
Relatively new financial markets, commonly known as emerging markets, may be much more volatile than U.S. stocks. This could be due to political factors, economic instability, weaker regulatory oversight or extreme cycles of speculation and panic.
Investing in international stocks also involves currency risk. If a country’s currency is devalued relative to the U.S. dollar, any gains in stocks traded in that foreign currency will be reduced when translated back into dollar terms.
Even if a foreign stock is traded in the U.S., the value of the company’s earnings might be reduced in dollar terms if those earnings are generated in currencies which have been devalued. The reduced value of those earnings could hurt the performance of the stock traded in the U.S.
What Percentage of My Portfolio Should Be in International Stocks?
If you decide to invest in international stocks, you need to figure out how that segment of your investments fits in with the rest of your portfolio.
Sophisticated investors often do this by setting a percentage target for international investments. You can base such a target on a variety of things, as described below.
If you want your portfolio to reflect the total range of investment opportunities available, you could base the percentage you invest in foreign stocks on capitalization.
Capitalization is the market value of publicly traded securities. Since foreign stocks currently represent roughly 57% of all stocks worldwide, this would suggest that roughly 57% of your stock investments should be foreign stocks.
Note that most people don’t have their entire portfolio invested in stocks, so that doesn’t mean foreign stocks should be 57% of your entire investment portfolio. For example, if you are 60% invested in stocks, then a capitalization-based approach would mean foreign stocks should represent 57% of that 60%, or 34% of the total.
One drawback of basing your allocation on capitalization is that the higher prices of a market go, the greater the capitalization of that market becomes. This could result in your increasing investments in the most overvalued markets.
Generally speaking, younger investors are able to take more risks than older investors. This means they might be able to afford a greater allocation to international investments.
This principle may apply in particular to emerging markets, which may represent great long-term opportunities but could be subject to temporary disruptions in the near term.
You might want to determine the size of your investments not by setting a long-term target allocation but instead by being opportunistic. This means investing in specific foreign companies or countries you expect to do particularly well.
By historical risk/reward characteristics
Some investment models build a portfolio according to the historical risk/reward characteristics of each type of investment. The idea is to build a blend of both higher and lower risk investments, and to hold investments that have historically gone though ups and downs at different times.
A general flaw with this approach is that historical stock performance does not always repeat itself. This flaw is especially true with foreign stocks, since the risk/reward characteristics of a market may change as that market develops.
How to Invest in Stocks from Other Countries
Online brokers and robo-advisors make it easy for ordinary investors to invest in international stocks.
With an online brokerage account, you should be able to invest in foreign companies that trade on U.S. exchanges as well as in index or other funds dedicated to foreign or global investments.
Some brokerage accounts may even facilitate buying stock on foreign exchanges. However, you should check for the ability of this kind of trading before you open an account. Also, this may entail additional costs.
Robo-advisors construct portfolios based on your financial situation and goals. The models used to construct these portfolios may include allocations to foreign stocks, typically foreign index funds.
If you want to make sure that foreign investments are included in the portfolio created for you by a robo-advisor, check to see if that robo-advisor’s models include foreign stocks.
In an increasingly global economy, foreign companies make up a large portion of the world’s markets. That’s a good reason why they should also represent some portion of your investment portfolio.
Frequently Asked Questions
Q: Can a foreign money market mutual fund purchase American commercial paper?
A: That question can be approached two ways:
- If you are referring to a U.S.-based fund whose mandate is to invest in foreign securities, then the answer lies very much in the details of the prospectus. Even with a foreign investment mandate, a U.S. fund may have some latitude to invest in domestic commercial paper for liquidity purposes or for tactical investment reasons.
- If you are referring to a fund based in a foreign country, the answer would depend on both the laws of that country and the latitude of the mandate. Before you invest in any kind of fund based in another country, you should make yourself aware of how that country’s investment laws differ from those of the U.S.
In either case though, there are a number of things an investor should consider in this type of situation:
- Read the prospectus — labels can be deceiving. Mutual funds can be named for a type of investment that is the fund’s primary emphasis, but the investment objectives of the fund might give the manager substantial discretion to invest elsewhere. It is important to go beyond the title and read the prospectus to see just how much latitude the fund has.
- Scour the annual report. The annual report should contain a list of holdings, so you should review this for any fund you own to see if those holdings match your understanding of the investment approach.
- Consider currency risk when investing for income. Foreign income yields can look much more attractive than domestic ones, but often a high yield is a sign of a weak currency. Fluctuating exchange rates not only can negate the yield advantage you are seeking by investing in foreign securities, but it can also make the fund’s yield much more erratic than you might expect from an income investment.
- Pay particular attention to fees in income funds. High-quality U.S. commercial paper yields are running between nearly zero and about a quarter of a percent. With yields so low, you need to make sure that fees won’t wipe out the lion’s share of a fund’s income.
- Do not mistake money market funds for money market accounts. Money market accounts held at a U.S. bank carry the deposit insurance backing of the FDIC. Money market mutual funds, whether invested in U.S. or foreign securities, are not covered by the FDIC.
One of the dangers a low interest rate environment creates is that even conservative investors find themselves taking on extra risk in an attempt to find higher yields. That may be necessary, but it is important to understand the risks you are incurring.