With more than 4,000 publicly traded stocks in the U.S., why venture into international stocks?
The answer: Investing in international stocks can reduce your risk — and may even bolster your gains. Yet many U.S. investors invest in companies they know, resulting in what’s known as home-market bias.
What’s the right balance? According to a study by Nationwide Financial, the optimal allocation to foreign stocks — when returns are maximized and portfolio volatility minimized — is 40%. Yet U.S. investors allocate about 22% to foreign stocks on average.
When you’re just learning how to invest in stocks, going global may seem like a hassle. But it needn’t be. Here’s what you need to know about investing in international stocks.
How to invest in international stocks
The easiest way to add international stocks to your portfolio is by investing in U.S.-registered mutual funds or exchange-traded funds that track foreign markets.
Why U.S.-registered? To avoid potential risks and costs associated with investing in foreign markets (more on that below). What’s more, because mutual funds and ETFs are baskets of securities, their inherent diversification benefits relieve you of the onerous task of picking individual stocks.
These types of index funds offer plenty of options for investing internationally — there are funds that are country-specific, regional or track different types of markets (developed, emerging or frontier). And they’re readily available through most brokerage accounts.
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Once you feel comfortable dipping your toes into foreign waters, build up the international portion of your portfolio slowly — perhaps through dollar-cost averaging, a strategy of regularly buying an investment, irrespective of its price.
Finally, don’t feel pressured to stray too far from home. That 40% optimal allocation cited by Nationwide is aggressive compared with what many experts recommend — 20%-25% of your portfolio. How global you decide to go is based on personal preference and your risk tolerance. But by starting small and scaling up over time, you're likely to find the sweet spot for your international stock allocation.
International stocks add diversification
You know the idiom: Don’t put all your eggs in one basket. This advice is especially important when investing, because diversification — or owning a variety of stocks across different geographies, industries and sizes of companies — is a simple way to boost long-term investment returns while reducing risk.
Even though we live in an increasingly interdependent global economy, stock returns can and do vary widely around the world. Research shows that adding international stocks can help reduce volatility in your portfolio, protecting against risks specific to any particular region. Your returns may also benefit from the exposure to faster-growing segments of the global economy.
Understanding the risks of foreign stocks
Fear of the unknown is one reason many investors stick to home. And that attitude is not completely unjustified, as international stocks could add unforeseen risks to your portfolio — just what you’re trying to avoid through diversification. Here are four risks to be aware of:
“Fear of the unknown is one reason many investors stick to home.”
Turmoil. Some countries — and their markets — may be liable to violent swings from politics, economic uncertainty, foreign currency rates, corruption or even war. It’s hard enough to stay on top of the news at home, let alone track these issues in distant regions.
Data. More limited access to financial information may be another risk of investing internationally. Other countries have different rules for the breadth, type and timeliness of data that publicly traded companies must report, which can vary significantly from the norm in the U.S.
Liquidity. The U.S. is home to the largest stock exchange in the world, which means there’s generally an ample market of buyers and sellers. That may not be the case elsewhere, with lower trading volumes or more limited trading hours — both of which could make it more difficult to buy or sell when you want.
Legal recourse. The Securities and Exchange Commission protects investors from fraudulent activity — but it focuses primarily on the U.S. market. When buying foreign investments, you may not have the same access to certain legal remedies as you would when buying a U.S.-based stock.
Managing the costs of international stocks
Generally speaking, you should expect higher associated costs when investing internationally. That shouldn’t dissuade you (remember all the benefits above?), but be sure to check with your broker about the following before placing a trade:
Foreign taxes on dividends for investments held outside the U.S. (though you may be eligible for a tax credit when filing your U.S. income taxes).
Transaction costs, including broker’s commissions or expense ratios (the fee to manage the fund).