Stocks are obviously not unique to the United States. In fact, the U.S. equity market makes up less than half of the global equity market, so there are indeed many opportunities for investing in stocks abroad. You should note, however, that foreign stocks, while similar to domestic stocks, are different in some important ways. This section takes a look at foreign equities and highlights some of the important differences you should know if you are going to consider investing in them.
The number one reason most financial experts cite when advising investors to consider foreign securities is diversification. The logic behind this reasoning is simple enough: if the U.S. happens to be suffering from an economic downturn or high inflation, there are probably going to be better investment opportunities abroad. Those investments abroad could help boost a portfolio weighted heavily in US equities when the U.S. stock market is not performing well.
But not everyone agrees with this reasoning. Academic studies have shown that while global diversification seemed to work quite well for many years, sometime during the late 1970s it stopped helping returns. A number of different reasons have been cited as to why this might be the case, including an increasingly global marketplace that has reduced economic differences among countries.
Whether or not these arguments are correct remains to be seen. There are, however, a number of different risks associated with foreign stocks that are beyond doubt. There is, for example, country risk. While U.S. markets have performed well over the very long run, this is not necessarily the case with all foreign countries. Many countries suffer from political, social, and/or economic instability that makes investing in those countries very risky. Furthermore, foreign governments have different rules regarding the regulation and taxation of securities that could be at odds with your investment objectives. Before investing in any foreign country, learn about that country’s political, social and economic conditions, as well as its tax laws and securities regulations.
In addition to country risk, there is also something called currency risk. Currency risk is the risk that your investments abroad might decline in value because of fluctuating currency rates. In general, the stronger the U.S. dollar becomes against a foreign currency, the more you lose when investing in that country. This is because you must convert your dollars into the foreign currency in order to purchase securities there and later convert the foreign currency back into dollars when you sell the securities. If the dollar is stronger against the other currency when you are exchanging the money for the second time, you will lose some of its value. Of course, it also works the opposite way: a weaker dollar can help to boost your returns.
Since purchasing foreign securities can be quite difficult due to the exchange of currencies involved, the investment community has developed a few different ways for you to purchase foreign securities more easily. Perhaps the easiest way for you to buy foreign stocks is through a global or international mutual fund. Mutual funds bundle together different securities from around the world in a number of different arrangements, so you can probably find what you are looking for whether it’s emerging market equities or equities from around the world. Note that this wouldn’t eliminate country or currency risk, but these risks would be managed by a professional who has expertise in these areas.
Besides mutual funds, you can look into purchasing what are known as American Depository Receipts (ADRs). ADRs were first created by U.S. banks in 1927 in order to make it easier for investors to buy stocks from abroad. ADRs are created when a U.S. bank purchases a large number of shares in a stock and then bundles them together and reissues them on one of the major American stock exchanges. In other respects, ADRs behave just like ordinary domestic stocks. They are a great way to invest in foreign securities since they reduce administrative costs and the costs associated with exchanging currencies. Foreign companies also benefit from having their stock converted into ADRs because it gives them greater exposure to U.S. investors.
Types of Foreign Stocks
Of course, not all foreign stocks are the same. As mentioned previously, countries across the globe vary greatly in their political, social and economic systems. This means that you may want to invest in foreign stocks from one part of the globe but not from another. In general, there is a distinction made between emerging markets stocks and other foreign stocks. Emerging markets stocks are stocks from companies located in countries that are undergoing significant economic transitions, such as developing Third World nations or the nations of the former Eastern bloc. Because these countries are in transition, the risks of investing in their stock is much greater than investing in the stock of companies from, say, Japan or Western Europe.