Personal Finance: When 'risky' means 'safer'
It's a global economy. Investors realize that. In fact, a majority of U.S. shareholders understand that having some exposure to international investments is probably worthwhile. Yet, a survey released this week by the National Association of Investors Corp. (a group that represents investment clubs) found that only 1 in 3 investors feels "comfortable" putting money to work in foreign stocks or bonds.
Why? It has nothing to do with the recent performance of foreign investments. Over the past three years, the average foreign-stock fund has gained 12.6 percent a year. Compare that with the 9.3 percent annual returns generated by U.S. stock funds.
Instead, investors seem to be fearful of the risks associated with foreign investing. After all, there are greater economic, political, and currency risks in many foreign countries than here at home. And mutual funds that invest in foreign stocks are still more volatile than those that invest in U.S. shares, according to the fund tracker Morningstar.
But what individual investors need to know is that sometimes a "risky" investment, in modest doses, can actually make a diversified portfolio of holdings less risky.
The whole point of diversification is to own investments that don't move in lockstep with one another. That way, when one group of investments (say, U.S. stocks) moves in one direction, the other holdings in your portfolio (perhaps bonds and foreign stocks) are likely to move in the other direction or stay put-therefore minimizing losses among your holdings.
Consider this: A portfolio of U.S. stocks returned 9.9 percent a year over the past decade, with a "standard deviation" of 15.6. (Standard deviation is a mathematical expression of volatility; the higher the figure, the more volatility.) By contrast, had you invested 40 percent of that money in foreign equities (with the rest kept in U.S. stocks), your portfolio would have gained 10.4 percent over the past 10 years-with a standard deviation of 15.4. That's right, the portfolio that included foreign holdings was less risky while still returning more.
So, what are the rules when it comes to foreign investing?
- Have at least some of your equity holdings-say, 20 to 30 percent for starters in foreign investments.
- Make sure those foreign stocks are well diversified among different companies and a variety of countries. The easiest way to do that is to use a mutual fund that invests in foreign stocks. To find some of the leading foreign-stock funds, go to www.morningstar.com.
- Remember that there are basically two types of foreign stocks: shares of companies in developed countries (such as Japan and Western Europe) and shares of firms based in emerging markets (like South Korea or Brazil). Emerging-market stocks are far more volatile-and are much more prone to lose money in any given year-than foreign stocks in developed markets.
- If you're adding emerging-market stocks, don't go overboard. Many financial advisers warn against putting more than 5 to 10 percent of your overall portfolio into these investments.
Paul Lim edits the Money Watch page for U.S.News & World Report.