To Beat the Weak Dollar, Invest Overseas
Six tips for buying foreign stocks
If only you'd listened.
Two years ago, Wharton finance professor and investing sage Jeremy Siegel raised eyebrows when he suggested that American investors keep 40 percent of their stock holdings in foreign shares—more than double what the average investor owned at the time.
If you had followed his advice and traded in, say, an index fund tracking the S&P 500 for one that follows the global markets (like, for example, Vanguard's Total International Stock Index Fund), you'd have more than doubled your gains. If you had stuck your neck out a bit further and bought into, say, an index fund that tracks emerging markets (like Vanguard's Emerging Markets Index), you'd have trounced the S&P fourfold—and nearly doubled your money.
Still, if you prefer the slow boat to China, it's not too late to hit the water. Until now, the steady decline of the U.S. dollar has been a big reason to own foreign stocks, since they're denominated in other currencies: The value of the greenback has fallen by nearly 15 percent over the past two years, and by nearly a third since 2003. And investors from Warren Buffett to George Soros predict the dollar will stay weak, as the nation's $8.9 trillion debt grows by more than a billion dollars a day. That means an investment in foreign stocks comes with a built-in currency dividend, at least in the short term.
But there are other important reasons to invest overseas, besides the currency bump. Here's what you need to know to invest smartly in foreign stocks:
It's the global economy, stupid. The case for buying foreign stocks has less to do with the shrinking dollar and more with the fundamental forces behind its decline. In many countries, the economy is growing far faster than the paltry 3 percent annual growth we're now logging in the United States. Markets in places like China and India aren't simply "emerging." They're rapidly joining—and even overtaking—the developed world as their production and consumption surge and their populations become more prosperous.
Meanwhile, mainstream economies in Europe and Japan are performing better than they have in decades, as behemoths like Japan's Toyota and Spain's Telefónica take larger shares of the world's markets. Little wonder that, for the first time ever, the total value of the European stock markets recently surpassed that of U.S markets, which now represent only about one third of the $51 trillion in global equities. That's down from a 46 percent share a decade ago.
Americans underinvest overseas. The reason, say economists, is the same fear of the unknown that has long kept two thirds of Americans from traveling abroad. Known as the "equity home bias," the tendency to keep a disproportionate share of your investments at home is rooted in a host of long-held but largely irrational fears. Hostile foreign governments, for instance, might seize the assets of private companies, as Venezuela did recently—yet the companies most affected were based in the United States, not other countries. U.S. investors also tend to feel that foreign accounting and legal standards are below those in the United States—even though our system produced the Enron and WorldCom debacles. Or they worry that financial information about foreign companies is simply too hard to come by, even though Reuters, the Financial Times, and other companies have it covered.
U.S. ownership of foreign stocks has ticked up recently, but by less than 2 percent annually since 2000. And most of that is due to appreciation. Less than one fifth of the typical U.S. portfolio is invested in foreign shares.
Foreign investing is a smart way to diversify. With such a large portion of the world's public companies now overseas, leaving them out of your portfolio "is like saying, 'I'm only going to invest in companies with names that start with A through F,'" says Siegel. Even emerging markets, he points out, boast large, well-run firms like PetroChina—Asia's most profitable company—and Korea's Samsung Electronics.
Siegel advocates a big stake in foreign equities not because of their potential for heftier annual returns but because they can lower the risk of putting too many eggs in one basket. Global stock markets do tend to move together over the short-run, such as the Dow's sell-off in February in response to a sudden drop in the Shanghai index, or the surge in European markets that inevitably follows a big day on Wall Street. But "there's no correlation between them over the long run at all," explains Siegel. "So by diversifying globally, you're spreading your bets and reducing your risk."
It's best to raise your foreign holdings gradually. The first order of business is figuring out exactly how much foreign stock exposure you have, and settling on an appropriate proportion. Most brokerages offer online programs that automatically track your diversification. But be sure to check your U.S. mutual funds, too, as many have increased their foreign holdings recently. (According to Morningstar, the average U.S. fund now holds about 7.4 percent in foreign equities.)
What's the right proportion? Given the stock market's recent volatility, Siegel recommends starting with a 15 percent investment, then using dollar-cost averaging to steadily build your total foreign portfolio to the proportion you've chosen. "Go in over time," he says. "That way you don't have to worry about getting in at the peak."
If you plan to retire soon, or might need to cash out, go light on foreign stocks, as the fact that they're denominated in foreign currencies also represents a risk. "When you cash in and retire, you'll be spending your money in U.S. dollars, so it makes sense to have the bulk of your portfolio in U.S. dollars," says Wall Street Journal personal finance columnist Jonathan Clements. Nevertheless, he advocates keeping about 30 percent of your total stock portfolio in foreign shares.
Divvy up foreign stocks just as you would a U.S. portfolio. Clements suggests putting half of your foreign holdings in blue-chip stocks from developed countries (such as iShares MSCI EAFE-based index fund), then splitting the rest evenly between an emerging market index (like iShares Emerging Markets Index) and a small-cap stock fund (such as T. Rowe Price's International Discovery fund). He and Siegel both favor broadly diversified funds, such as Vanguard's Total International index fund, an amalgam of its European, Pacific, and emerging markets funds, as well as exchange-traded index funds, such as those that track Morgan Stanley Capital International's benchmark EAFE (Europe, Australia, and the Far East), Japan, and Emerging Markets indexes.
For once, don't hedge! Whichever funds you choose, Clements advises, "make sure they don't hedge their currency exposure." Hedging, after all, would dilute the benefits of investing overseas. "Half the benefit of owning foreign stocks," Clements points out, "is that you can diversify the currencies you hold." Then, weak dollar or no, you'll have plenty of pesos to spend when you retire to that Mexican villa.