When aiming to create a diversified portfolio, many investors assume that international exposure is a necessary component. This makes sense, considering that roughly half of global stock market value is based inside the United States while the other half is generated abroad. International investing is important for some, particularly larger investors with long time horizons and a higher tolerance for risk. It may not be as important for investors with smaller portfolios or those who don’t have a good grasp on the potential risks involved. Let’s take a look at how international investments are characterized and how you can potentially incorporate them into your investment portfolio.
Developed Markets vs. Emerging Markets
The United States has a well-developed market with a strong currency and a very robust economy. Many investors feel confident that investing in U.S. corporations can offer the potential for growth and a minimal, though nontrivial, risk that one of those corporations will go bankrupt. Internationally, there are both developed and emerging markets. In addition to the U.S., developed markets include Canada, Australia, Japan, and the United Kingdom, among others. While there is no precise definition of what makes a market developed, there is a general expectation of the following characteristics: a robust economy and capital market, a fairly high average per capita income, and the ability of capital and goods to move freely in and out of the country.
Emerging markets, on the other hand, are generally characterized by heightened political risk and various economic hurdles. Those hurdles might include reliance on foreign capital, unstable currency, and dependence on a single major export such as oil. Popular emerging markets that attract foreign investment include Brazil, Russia, India, and China, often referred to as the BRIC countries. There are plenty of less developed emerging economies, as well, such as Argentina, Croatia, and Vietnam.
Incorporating International Investments in Your Portfolio
When trying to decide how to include foreign companies in your portfolio, a good start might be to consider stock in firms that trade in a developed market (such as Europe) and whose products may be recognized in the United States. In today’s global economy, many large European companies rely on the U.S. for a significant portion of their sales. The reciprocal applies to many U.S. companies, which rely strongly on international markets for some portion of their sales.
For investors who either can’t buy stocks on an international exchange or who wish to avoid some of the headache associated with doing so, ADRs (American Depositary Receipts) allow investors to buy foreign shares that trade domestically. The price of an ADR will track the price that the security trades at on its home exchange. While ADRs provide convenience and access to foreign stock shares, they do not eliminate the currency exchange rate. Any bank that acts as an intermediary for ADR shares will reflect the currency fluctuation in the price of the shares. You may not notice this process, but it is happening.
Accessing the global market has become easier with the proliferation of exchange-traded funds (ETFs). Now, index-tracking investments can offer exposure to international markets, ranging from individual countries to “world indexes” that combine the world economy into a single investment with relatively low expenses. The international bond market can be a bit more complicated to access through ETFs alone. There are mutual funds that focus on specific parts of the international markets and for some investors, this product may complement the use of ETFs.
International exposure is important if you want to build a portfolio that truly reflects the global economy. However, it is important to remember that unique risks are involved with investing abroad, some of which don’t necessarily affect U.S. companies. The key, as always, is to ensure that you are diversified, maintain a long time horizon, and select investments that present a favorable risk vs. reward scenario.