International Developed. Emerging Markets. Frontier Markets. Perhaps you have heard these terms before but are unsure exactly what they mean. In this blog, we’ll break down foreign investing so you can make smarter decisions on whether or not it’s right for you.
Foreign Investing Simplified
What comes to mind when you think of foreign investing?
“I have no clue.”
Here in the U.S. we are fairly familiar with the U.S. stock markets, but foreign markets can remain a mystery. But this oversight could leave you with an investment portfolio that is less than optimal.
In this post we’ll cover:
- What is Foreign Investing?
- What Does Investing in Foreign Stocks Return (Historically)?
- Is Foreign Investing Risky?
- How to Invest in Foreign Stocks?
- How Foreign Stocks Affect a Portfolio
- Is Foreign Investing Right for You?
What is Foreign Investing?
It’s a Big Ocean Out There
According to Bloomberg, the capitalization (or total value) of the entire world market in 2016 was 65.6 trillion. Of which, the U.S. market is only worth 23.8 trillion. As you can see, there is a whole lot of market value outside of the U.S.
But it’s more than just U.S. stocks vs non-U.S. stocks. Foreign stocks can be broken down into further categories. In terms of economic development, the countries of the world are not equal. There are industrialized countries and there are countries who are still figuring it out. Today, foreign markets are commonly broken down into three categories:
Investing in foreign markets has historically been seen as a way to diversify your portfolio. That simply means spreading your money into different types of investments to reduce your risks. The thought is that the U.S. stock market and foreign stock markets are different and so would not be highly correlated (mutually connected or dependent).
Developed foreign markets are commonly categorized under the MSCI EAFE Index. EAFE stands for Europe, Australasia and Far East. These countries are more industrialized, wealthy and have a higher standard of living. Countries included are shown in the table below.
Emerging markets are countries with economies that are breaking out and becoming more industrialized but have not quite reached the status of most industrialized countries. Countries included are shown in the table below.
Every time I hear “Frontier Markets” I always picture a John Wayne or Clint Eastwood western. And the picture fits. Frontier markets include countries like Argentina, Kuwait, Morocco, Vietnam and Nigeria. These countries are under development but still too small to be considered emerging.
What Does Investing in Foreign Stocks Return (Historically)?
In his book, Portfolio Design, Professor of Finance and Director of International Financial Research at the Wharton School Richard Marston showed that the MSCI EAFE Index outperformed on average the S&P 500. The table below illustrates his findings.
As you can see, from 1970 to 2009 the developed markets of the MSCI EAFE returned on average greater than the S&P 500, which is one of the main U.S. stock market indexes.
What about emerging markets? Marston discusses these as well. In table 6.2 below, we see that emerging market returns vary among themselves but are higher than both developed foreign markets and the S&P 500
Is Foreign Investing Risky?
As with any investment, the level of risk is determined first and foremost by your unique personal and financial circumstances. Speaking for a single investment, risk can be defined as the probability or likelihood of the occurrence of losses relative to the expected return. The technical measurement we use in investing to measure risk is called the standard deviation. Standard deviation is simply the measure of how much an investment’s returns can vary from its average return. The smaller the standard deviation, the less volatile (extreme swings from the average) the investment is. The larger the standard deviation, the more the returns of that particular investment will be dispersed.
Thus, if we compare the standard deviation of the developed markets of the EAFE, emerging markets using the MSCI Composite and the S&P 500, we can gain an understanding of risk on a relative basis. For example, if we review table 6.2 above, we see that the standard deviation of the S&P 500 from 1989-2009 is 14.9%. The developed foreign markets of the EAFE are slightly more volatile, with a standard deviation of 17.5%. Emerging markets, categorized by the MSCI Composite have a standard deviation of 24.7%, which is significantly higher than the other two. That being said, using standard deviation as a measure of risk we could conclude that the less developed the foreign markets, the more dispersion of returns will occur.
In investing, there is something called the risk/return trade-off. This trade-off tells investors that the higher the risk the higher possibility of higher returns. However, also the higher possibility of higher losses. There are no guarantees.
There are some additional risks that are worth considering when talking about international investing. Those include currency risk, transaction costs and liquidity risks. Depending on your method of investing internationally, these risks may apply.
How to Invest in Foreign Stocks?
There are multiple ways you can invest in foreign stock markets. The most common investment that investors use are international mutual funds or Exchange-Traded Funds (ETFs). A benefit is that you are not investing in one particular company but a diverse basket of many companies. That way if one company does poorly, it has less of an effect on your portfolio. There is a wide variety of these investments available. You can invest in a single country, region, continent or the entire world. Not only that, but since they trade like any other fund or ETF, they aren’t very expensive to trade and are relatively liquid.
You can choose to be a bit more complicated and invest directly in foreign companies on overseas exchanges or you can invest in American Depositary Receipts (ADRs), which are listed on U.S. exchanges and mimic closely the stocks listed on foreign exchanges. Some investors choose to gain foreign exposure by purchasing stock in U.S. companies that are heavily dependent on foreign business.
The right investment type ultimately depends on your unique financial circumstances but most investors choose to go with the diversification and relatively cheap and liquid option of international mutual funds and ETFs.
How Foreign Stocks Affect a Portfolio
Investing in international, non-U.S. equities is most often justified by a desire to increase returns and also to obtain diversification benefits. So how does investing in foreign equities affect a portfolio? Marston analyzes this as well. For the purposes of this blog post I will use the developed EAFE index data. Table 5.5 below shows both average performance and standard deviation over multiple time frames when adding an EAFE position. Interestingly, the change in performance is negligible, however the standard deviation of the portfolio is actually reduced. This means that the portfolio would experience less volatile swings.
Is Foreign Investing Right for You?
Given our analysis of foreign investing we can see periods where investment returns in both developed and emerging markets outperform the S&P 500. We also saw how the addition of developed foreign stocks to a portfolio can help reduce the overall standard deviation. Given these benefits of both potential returns and diversification, investing in foreign equities is worth consideration.
That being said, I know that putting this into practice is easier said than done and you might have additional questions. I make getting answers really simple. Just use my confidential contact form and shoot me a message, or feel free to email me directly at firstname.lastname@example.org and I’ll do my best to help point you in the right direction.
Until next time.
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Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Vision Wealth Partners clients. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Vision Wealth Partners assumes no responsibility for the tax consequences to any investor of any transaction. Past performance is no guarantee of future results.
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