Beyond investment diversification, international stocks will protect you from an uncertain political environment here at home
Investors are surrounded by the evidence of a global economy.
Our phones are made in South Korea, televisions from Japan, wine from Argentina—even our coworkers may be located in far-off continents.
But while our lives may have gone global, our investment portfolios have not kept pace. Data from Fidelity customers suggest that millions of investors have no international or emerging market stock investments at all.
Why should that be a problem? Most large U.S. companies get some sales from overseas so isn’t that enough global investment diversification?
Adding international stocks to your portfolio not only offers the potential to spread your investment risk to companies operating throughout the world but also diversifies your portfolio in different economic cycles and currencies.
In fact, adding international stocks to your portfolio has been shown to increase returns and decrease risk compared to a portfolio of stocks only in U.S.-based companies.
Special types of stocks and funds have made it easy to invest in international stocks. Use this guide to get the most from foreign stocks and diversify your portfolio.
International Stocks and the Power of Global Diversification
A fundamental reason to consider international investing is diversification. A big part of choosing your mix is to seek investments that are not perfectly correlated—that means including investments that provide the potential for gains in one part of your portfolio to offset poor performance in another.
That’s true for asset classes—stocks, bonds, and cash—but also for countries and currencies. By diversifying, you may be able to achieve returns similar to those of a less-diversified portfolio, but with less risk, or you may be able to achieve greater returns, but with the same amount of risk.
Keep in mind, though, that diversification cannot ensure a profit or protect against loss and that decisions about your investment strategy should be based on your personal goals, situation, and risk tolerance.
I’ll focus mostly on the diversification benefits to international investing but there’s one very important reason U.S. investors need to globally diversify their portfolios now, like right now.
We’ve seen ever increasing political discord over the last several elections and the party-line split has grown to an unthinkable chasm. Stocks of U.S. companies have surged since the election on the hope for business-friendly reforms but the likelihood of President Trump being able to push his policy promises through Congress is in doubt.
Democrats are fiercely fighting policy changes and even some Republican groups are pushing back against proposed reforms.
If Washington can’t deliver on its economic promises, investors in U.S. stocks could be in for a rough couple of years.
All of this is happening as central banks in Europe and Japan continue to pump money into the system and economies abroad are picking up growth. International stocks may provide the only reliable growth over the next few years.
Lower Risk and Higher Return with a Foreign Stock Portfolio
International investments have shown the ability to improve risk-adjusted returns. Since 1950, a globally balanced portfolio that included developed-market stocks has returned slightly more than the S&P 500, but with significantly less risk.
The table shows that international stocks, on their own, have underperformed U.S. peers slightly over the 64 years. Add international stocks to a U.S.-focused portfolio though and something magical happens.
Adding 30% foreign stocks to a portfolio increases the annualized return and decreases the risk, measured by standard deviation. The Sharpe ratio, a measure of risk-adjusted returns, actually increases when foreign stocks are added.
That’s because international companies operate in different economic cycles and in different currencies. When the U.S. economy heads into a recession, other countries may do relatively better and vice-versa.
U.S. versus International Stock Returns
Finding investments in international stocks is easy with American Depository Receipts (ADRs) and foreign stock funds.
ADRs are stocks traded on the U.S. exchanges that represent a number of shares in a foreign-owned company. The foreign company deposits a number of shares with a U.S. custodian, usually a large investment bank, and then shares are issued in the U.S. markets. Investors can buy the ADR shares just like any other stock.
There are also hundreds of exchange traded funds (ETFs) designed to give investors exposure to international stocks and investments. These funds hold ADR shares as well as shares of foreign companies in their local markets. Investing in these ETFs gives U.S. investors the added benefit of accessing international stocks that might not be available as ADRs on the New York Stock Exchange.
While U.S. companies have soared over the last few years, international stocks have outperformed their U.S. peers in other periods. The chart shows outperformance of foreign stocks versus U.S. equities going back to 1970.
Neglecting international stocks would have meant missing out on some serious gains in the mid-80s and the early part of the 2000s.
Finding Opportunities in International Investments
Beyond diversification, there are some strong reasons to consider international markets based on the fundamental outlook for opportunities among these stocks.
Approximately 75% of the world’s publicly traded companies are found outside the United States. That means a lot of opportunities exist beyond our borders. Sure, lots of U.S. companies get some of their revenues from abroad, but in an increasingly global economy, some industry-leading companies are located in foreign countries.
To tap into those best-of-breed companies, you may have to look at international markets.
Most of the fastest growing economies in the world have been outside the U.S. In 2001, the U.S. accounted for 33% of global GDP, but by 2014 the U.S. represented just 22%. Other economies have grown more rapidly, helped in some cases by attractive demographics or less mature markets.
Investing in emerging market stocks can add another layer of growth beyond simply diversifying your portfolio with international stocks. Emerging markets offer the fastest economic growth in the world and companies that could lead their industries over the coming decades.
Step-by-Step Emerging Market Investing walks you through everything you need to know about taking advantage of growth and returns in EM stocks. Besides detail on how to find the best emerging market opportunities, the book includes a guide on the different emerging regions and countries to narrow down your investment choices.
Some of my favorite funds for international investing:
- Vanguard FTSE All-World ex-U.S. ETF (VEU)
- Vanguard FTSE Developed Markets ETF (VEA)
- Vanguard FTSE Emerging Markets ETF (VWO)
- iShares USD Emerging Markets Bond ETF (EMB)
Investing in international stocks doesn’t mean you need to be an expert in foreign economies or have special access to markets all around the world. International diversification is critical to growing your portfolio and reducing risks here at home. I recommend investors hold at least 20% of their portfolio in ADRs or exchange traded funds focused on foreign stocks.