Diversification is an essential investing principle. It protects a portfolio from being seriously affected by negative events isolated to only a few stocks. In this article, we take a look at diversification that ventures into an international level, looking at its benefits and the different types of international investments available to the average investor. (To learn more, see The Importance Of Diversification.)

TUTORIAL: Money Market

Why International?
Most investors tend to invest in what they know. This isn't necessarily a bad thing as it's important to have a good understanding of your investments; however, it becomes detrimental when the blinders are put on and people refrain from learning about other investments. International investing, in particular, is a strategy sometimes overlooked by investors as a means of diversification.

With all the volatility found in stock markets, it's difficult enough to pick winning stocks let alone winning economies. This is where diversification through international investing can help. Every year, the economic performance of a country will fluctuate and this undoubtedly affects the stock market. By buying securities in different markets as opposed to purchasing only U.S. stocks and bonds, you can reduce the impact of country or region-specific economic problems. (For more information, see Can You "Learn" The Stock Market?)

Take a look at the following chart:

Year Japan Nikkei U.S. S&P 500 Canada S&P TSX Composite London FTSE 100
1993 18.8% 9.7% 30% 24.3%
1994 -7.8% -2.3% -11.8% -14.3%
1995 11.6% 35.8% 23.7% 25.7%
1996 -11.9% 23.6% 23% 13.7%
1997 -12% 24.7% 9.7% 27.7%
1998 -12.8% 30.5% 0.4% 8%
1999 35% 9% 26% 6.3%
2000 -29% -2% 9.9% 0.5%
2001 -27.8% -17.3% -17.9% -18%
2002 -16.6% -19.6% -11.5% -30.9%
2003 22.53% 22.38% 21.97% 11.66%
2004 6.13% 9.48% 11.70% 6.87%
2005 40.86% 3.84% 23.29% 15.92%
2006 4.87% 11.78% 12.23% 8.86%
2007 -10.44% 4.37% 10.10% 3.02%
2008 -40.51% -37.58% -37.31% -31.96%
2009 17.59% 19.67% 26.19% 17.87%
2010 -3.64% 11.00% 13.21% 8.12%
2011* -16.67% -2.82% -11.09% -9.27%
* As of December 2011

This chart outlines the percentage returns on the indexes of international exchanges. With careful inspection, we can see that the magnitude and direction of returns for these four indexes don't always coincide. There are years when one index is up while another is down, and other times when an index rises by nearly 36% while others rise only by 12%. By participating in these other markets, that is, through purchasing securities from other countries, an investor can, with the added benefit of higher returns in foreign exchanges, add some protection against a national downturn in the U.S. economy.

Different Types of International Investments
There are numerous ways in which the ordinary investor can invest in foreign markets without having too much trouble. Here are a few of the major types offered by most brokerages.

American Depositary Receipts (ADRs)
American depositary receipts are used by foreign countries unable to list on the NYSE or Nasdaq, which have domestic country regulations. ADRs mimic their domestic stocks very closely, and offer you a way of investing internationally without actually buying stock from a foreign exchange. One ADR found on the NYSE is Nokia (NYSE:NOK). This company tracks its parent stock on the Helsinki Exchange almost identically, allowing investors the convenience of international diversification without actually leaving American exchanges. (To learn more, see What Are Depositary Receipts?)

Exchange-Traded Funds (ETFs)
These investments offer a wide variety of international flavors. You can buy ETFs that track most of the major foreign indexes, and they allow investors to obtain a return based on a specific foreign market without having too great of an exposure. Also, because they trade and work like any other ETF, they aren't expensive to trade and are relatively liquid. (To learn more, see Introduction to Exchange-Traded Funds.)

International Funds
International stock funds are comparable to international ETFs as they also provide for diversification but have same drawbacks and benefits that are associated with regular funds and ETFs. One thing to remember is that in these international funds, a hired professional portfolio manager is in charge and decides what to place in the portfolio. Be sure you do your research before buying such a fund to make sure that these investments and the trading strategy of the fund are in line with your preferences.

Foreign Securities
Many brokerage firms will offer investors the ability to buy investments from different countries directly from the brokerage's international trading desk. So, if you wanted to buy a stock in a company that doesn't trade on American markets, you can inquire with your brokerage to see if it will facilitate the trade for you through one of the brokerage's affiliated international companies that has a membership on the foreign exchange or market. Because these trades are typically more expensive and less liquid than regular domestic trades, you should carefully check out all of the other alternatives before you decide to do it this way.

Not recommended for the beginner investor, these are bonds issued in foreign markets by domestic companies. An example of this would be if Sony were to issue a bond that matures in yen for American investors. Eurobonds don't always offer higher yields than domestic bonds, and they are only as secure as the company issuing them, but they are a way you can participate in a foreign fixed-income market. One of the main reasons that beginner investors should be wary of these bonds is that they pay a foreign currency that the investor will probably have to exchange.

Aside from allocating assets amongst different securities and industries, international investing is a good alternative for diversification. It reduces the impact investors experience from the downturn of a specific economy and helps to increase returns on portfolios concentrated in domestic markets that are no longer growing at a rapid rate. Furthermore, the availability for international products has increased dramatically with the globalization of equity markets, so even the average investor can take advantage of the benefits without paying too much. Before you decide upon diversifying internationally, be sure you research your investment closely so that you can make an informed decision.

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