Here's an exercise for those who think they don't need foreign investments in their portfolio: Look at the labels on your possessions. Are they all made in the United States, or do they take on an Olympic flavor? Perhaps your clothing hails from Mexico or Taiwan, your car comes from Europe and your electronics from Japan.
Those foreign labels should signal two things to you as an investor: One, to maintain your current buying power, you need a certain amount of international exposure, says Donald Gould, president of San Mateo, Calif.-based Franklin Templeton Global Trust. Two, there are some great companies producing world-class products overseas. That spells opportunity.
"It used to be that the U.S. dominated the world economy, so it was appropriate for U.S. investors to ignore the rest of the world," says James J. Atkinson Jr., director of Guinness Flight Global Asset Management Ltd. in Pasadena. "But you can't make that claim anymore."
Indeed, though the U.S. stock market remains the biggest in the world, foreign markets now account for about 60% of the world's stock market capitalization, notes Mark Geist, president of Montgomery Asset Management in San Francisco. Concentrating all your dollars in the domestic markets means you're ignoring 60% of the world's investment opportunities, he says.
"We are in an environment of global companies, global distribution and global consumerism," Geist adds. "Every investor should have a portion of their portfolio invested globally too."
But what may be the most compelling reason of all to invest in foreign markets is this: A host of independent studies suggests that international investments have had an unusual effect on diversified portfolios. They reduced the overall risk and modestly increased the potential return, says James E. Andelman, consultant with Ibbotson Associates in Chicago.
Historically there has been little link between the performance of U.S. and foreign stock markets, says Andelman. In other words, when U.S. stocks are rising, foreign stocks could be falling, and vice versa.
Because the markets can move at different times and at different speeds, foreign stocks can smooth out the bumps in your domestic portfolio. That does more than save you money on antacids. It actually improves your portfolio's performance over time. Even as world economies become more interdependent and inter-related, many analysts think this state of affairs is likely to continue.
But even the biggest advocates of foreign investments agree that they are best taken in moderation, because many foreign markets are more volatile than U.S. markets. In addition, currency risk can magnify these swings.
What is currency risk? All world currencies--whether U.S. dollars, French francs, Japanese yen or German marks, for example--fluctuate in value when measured against one another. When you buy stock in a foreign company, you buy the shares with that country's currency, after converting dollars to the currency at the going exchange rate. When you sell, you get paid in that country's currency, and you then must convert that currency back to dollars, at the going exchange rate.
If the exchange rate is significantly different between the time you buy and the time you sell, it can add to--or reduce--whatever return you earned on the stock itself. In some cases, the change in currency values can be more significant to your total return than the actual appreciation or depreciation of the particular stocks you purchased.
If the dollar weakens in value against another currency, you make money on the currency exchange, because each unit of foreign currency translates into more dollars. If the dollar strengthens against another currency, you lose on the currency exchange because each unit of foreign currency translates into fewer dollars.
To illustrate, consider a hypothetical individual, John, who invested $10,000 in Japanese stocks in April 1995--a time when the Japanese yen was at record strength against the dollar--and sold in October 1996.
When John bought, his $10,000 was converted into 843,000 yen worth of stocks, because $1 equaled 84.3 yen at the time. In yen terms, his stocks then appreciated a solid 20% over the period as the market rose, making the securities worth 1,011,600 yen when he sold.
But in the same period the dollar strengthened considerably against the yen; instead of 84.3 yen needed to equal $1, it took 114 yen to equal $1 when John sold. So after converting his yen to dollars, John came home with just $8,874--a $1,126 loss, caused solely by currency swings.
On the other hand, U.S. investors who bought Japanese stocks at the end of 1990 still have a positive return--even though the Japanese market is well below its 1990 levels--because the dollar's value has weakened significantly since 1990, from nearly 140 yen then to about 113 now.
Currency risk isn't the only worry for Americans investing abroad. Investing directly in international markets can be prohibitively expensive and inconvenient if you try to do it alone, says Montgomery's Geist. Fees are high, some stocks cannot be sold quickly and there are many delays in transferring funds. This is particularly true of smaller stock markets.
Of course, it is possible to buy some foreign stocks on U.S. exchanges. Such issues trade as American depositary receipts, or ADRs, and are quoted in dollars. Although increasing in numbers, there are still only a limited number of such stocks available.
For the most part, the simplest and most economical way to invest in international markets is through mutual funds. Although fund companies, too, must pay the brokerage, settlement and exchange fees involved, they're able to get better rates because they're buying in bulk. The costs also are spread among a larger group of investors.
Still, international mutual funds are not all alike. Some invest in single foreign markets, others invest in regions and others invest all over the world. Some try to hedge away currency risk, while others embrace it. . Then, too, some funds take a top-down approach to stock picking, choosing the countries first and the specific stocks second, while others pick the stocks of companies they like no matter the country the company is based in.
By and large, these differences are clearly delineated in each fund's prospectus, a detailed legal document provided to investors that spells out the fund's risks, strategies, fees and historical returns.
Savvy investors analyze whether a fund's investment strategy meshes nicely with their own. Consider, for example, whether you want your fund to bank on one country's economic strength or if you'd prefer a fund that has a broader reach. Does currency risk make you cringe, or can you handle extra risk with the potential for better rewards?
Do you want to invest in so-called emerging markets--less-developed countries, where stocks may experience tremendous volatility over the short run but could provide more generous returns over time? Or are you more comfortable investing in mature economies with track records--the Germanys and Japans of the world--because their markets tend to be more predictable?
Another option is so-called global funds, which differ from international funds in that they have the flexibility to invest a substantial portion of their assets in U.S. markets when fund managers think that's where the best opportunities lie. International funds, on the other hand, are generally required to invest the bulk of their assets overseas.
Foreign stocks also can be purchased via "closed-end" funds. Unlike open-end mutual funds, closed-end funds raise capital once and invest it. Their shares, which trade on major exchanges, can sell at a discount or premium to the true value of the underlying portfolio.
After you decide which type of fund is best for you, the only question is how much money you want to invest overseas. There's no pat answer, but experts advise individuals to dedicate anywhere from 5% to 25% of their portfolios to international investments. The more time you have, the more exposure you can handle in volatile--but potentially rewarding--foreign markets.
Next lesson: How to use tax breaks.
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How Currency Shifts Affect Foreign Stock Returns
When a foreign currency's value increases versus the U.S. dollar, that nation's stock market performance looks better for a U.S. investor. When a foreign currency weakens, it cuts into stock returns for a U.S. investor. A look at the 1996 performance of key markets in native currencies, each currency's change versus the dollar and the real return of each market for U.S. investors:
Country Market YTD% Currency YTD% Market YTD% (actual) (vs. dollar) (in dollars) Hong Kong +30.1 0.0* +30.1 Canada +23.3 -0.4 +23.7 Mexico +20.0 +2.9 +16.6 Germany +23.9 +7.6 +15.1 Britain +7.4 -5.9 +14.2 Italy +9.1 -3.9 +13.5 Australia +5.0 -6.8 +12.7 France +19.7 +6.4 +12.5 Switzerland +16.3 +14.1 +2.0 Japan +2.1 +9.5 -6.5 Korea -20.7 +7.3 -26.2
* Hong Kong dollar is linked to U.S. dollar.
Source: Bloomberg Business News. Returns are through Friday
An Example: Japan
The Japanese stock market was in the middle of a crash in 1990 and is now 15% below the year-end 1990 level. However, a U.S. investor who bought at the end of 1990 is still ahead 2.4% because the yen has strengthened against the dollar since then.
Stocks Are Lower ...
Nikkei-225 index, quarterly closes and latest:*
... but the Yen Is Up
Yen per dollar, quarterly exchange rates and latest:*
*as of Dec. 6
Source: Bloomberg Business News