Foreign stocks, equity securities issued by companies from other countries are a class of assets of considerable investor interest. But before proceeding to discuss it, let’s define the terminology. The definition of foreign usually refers to securities issued in other countries, i.e., not in the United States. Although this interpretation may differ from dictionary definitions, it is in this sense that it is used in the investment world, especially with regard to mutual funds.
The second group of definitions distinguishes between developed or industrialized countries and emerging markets. Emerging markets is an investment term referring to developing countries, or so-called less developed countries. This seemingly purely terminological question is very relevant for countries, since the name affects their ability to raise capital in global markets, get loans from banks, and – most importantly – means a lot to their national ego. Despite the importance of such a classification, at the moment there is no consensus on how to determine the status of a country and who should conduct such a classification. In some cases, there are no questions: the UK and Japan are developed countries, Malaysia is a developing country. With other countries, especially in southern and eastern Europe, things are not so clear. For example, it is assumed that Greece will “grow up” to the status of a developed country by the time it becomes a full member of the European Union.
For US investors who maintain their accounts in US dollars, investing in any foreign market involves a whole range of currency risks. Investing in emerging markets creates an extra layer of risk. We will start with foreign stocks of developed countries, after which we will briefly touch on emerging markets.
Investing in foreign stocks of developed countries
Investors who hold shares issued in other countries, there is a new reason for headaches – currency risk, since the main markets of these shares are outside the US and they are traded not in US dollars, but in local currency. In other words, in addition to the risks associated with falling stocks or funds, investors have to worry about currency fluctuations. Change in exchange rates of 10%, 20% and more during the year is not uncommon. The new common European currency, the euro, at the time of its introduction, was trading at $ 1.17, and a year later, the euro was given a little more than a dollar. Any investor with European stocks lost almost 15% during 1999 due to currency fluctuations, regardless of the result of foreign stock markets. Of course, the movement may be the opposite, and the US dollar exchange rate may fall and bring unexpected gains to foreign investors. The main thing is that investors should understand that international investment carries additional risks that are not available on the domestic market.
At the same time, there may be advantages. Markets in the US and other countries are not perfect copies of each other. Often, when one of them grows, the other can take a breather or even fall. Consequently, investing in foreign markets opens up the possibility of diversifying investments and reducing the overall risk of a portfolio. This is one of the main reasons for investing outside of your own country. Of course, some unforeseen shocks, such as the Russian default in the summer of 1998, give rise to devastating tsunamis affecting the entire globe, but most market movements at weekly and monthly intervals do not show a complete correlation. This means that diversification will work.
Even if foreign markets can reduce risks through diversification and generate unexpected profits due to fluctuations in exchange rates, they do not offer higher yields than the domestic market. In today’s global and interconnected world, there is no reason why a company in one industrialized country can be significantly more or less profitable than a company in another developed country. The automotive industry in Europe is no better and no worse than the automotive industry in the United States or Japan. Otherwise, car companies would quickly move to where better. And if this did not happen, the rise in stock prices in more lucrative countries and the fall in stock prices in less lucrative countries would quickly negate the difference. Markets work, and information spreads instantly. That is why you should not rely on super-profits when buying stocks in other developed markets.