Investing in foreign countries is a relatively new option for individual investors. Fortunately, the emergence of mutual funds and international-focused exchange-traded funds has made it easier than ever. But is investing abroad a good decision? As always, the decision to invest in foreign countries largely depends on your specific investment goals, but this article will explore some positive and negative points.
Why Invest in Foreign Countries?
The basic rule of investing is to seek the highest risk-adjusted return. Simply put, you want to maximize profits while minimizing risks in any given investment. One of the best ways to achieve that is through diversification, which has been mathematically proven to enhance risk-adjusted returns.
An effectively diversified portfolio contains at least eight to ten uncorrelated assets (or assets that do not move relative to one another) distributed across various industries and geographies, ensuring that a negative event in one market will not adversely affect the entire portfolio. As a result, investing in foreign countries (geographic diversification) is an important way to enhance risk-adjusted returns through diversification.
For example, the iShares MSCI EAFE ETF (NYSE: EFA) has a correlation of 0.80 with the S&P 500 SPDR ETF (NYSE: SPY), while the iShares MSCI Emerging Markets Index ETF (NYSE: EEM) has a correlation of only 0.51, according to data from ETFScreen.com (as of September 2021). Many domestic stocks and funds have much higher correlations, which reduces diversification.
Where Do Foreign Investments Fit?
The United States is globally recognized for its safe investments, such as Treasury bonds and reputable corporations. Likewise, foreign countries often have their own categories of investments, ranging from commodities to growth stocks. Thus, investors looking for these types of investments may want to consider using foreign stocks to fill gaps and enhance diversification.
Foreign countries in the group of emerging markets (Brazil, Russia, India, China) are primarily known for their growth opportunities. These nations have experienced substantial economic growth, aiding many companies to thrive. However, as with any developing country, there is an increase in risks associated with successfully managing growth over the long term.
Other countries are known for specific sectors. For instance, Nigeria is famous for its risky offshore oil industry; Chile is known for rare minerals; Canada is noted for gold and oil sands; the Middle East is recognized for its oil and gas opportunities. Each foreign country has its own economic focus and risk-reward profile for international investors.
Main Risks of Investing Abroad
There are risks in investing in any country or market, including the United States, which is why building a diversified portfolio is very important. For example, if the U.S. makes a mistake in monetary policy and the dollar deteriorates, it might not be so bad to be invested in other countries that are not affected by these events. However, there are many risks associated with investing abroad compared to local investments.
Here are three of the main risks:
- Currency exchange rate risk: Foreign companies often generate sales and income in their local currency, such as the euro or Swiss franc. Consequently, U.S. investors will need to convert these currencies to U.S. dollars at some point. Unfortunately, exchange rates fluctuate over time and can lead to unexpected gains or losses.
- Geopolitical political risk: Some foreign companies operate in countries that may face geopolitical risks, such as terrorism or potentially hostile neighbors. For example, South Korea faces the risk of being attacked by North Korea. Therefore, investors need to carefully consider the risks associated with the countries they invest in.
- Risk
Economic and Credit: Foreign companies often rely on the health of the economy of their host country. While the United States has a AAA credit rating, there are many countries with investment ratings ranging from perfect to below investment grade. Adverse economic events in these countries can impact the companies operating within them.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
ETF Screen. “ETF Correlations with SPY.”
Source: https://www.thebalancemoney.com/should-you-invest-in-foreign-countries-1978967
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