One of the many difficult decisions that an investor has to make is whether or not to invest in foreign stocks. Investing in foreign companies can be lucrative, but the rewards come with additional risks. As an investor, it's important to research the risks and rewards of international stocks before investing.

Key Takeaways

  • Because U.S. stocks represent only approximately 43% of the total value of global markets, international stocks represent an added opportunity for investors.
  • From a portfolio management perspective, investing in foreign companies is one way to diversify an investment portfolio.
  • Investing in foreign markets can also expose you to risks associated with exchange rates, political or economic instability, and differences in reporting and tax regulations.

Foreign Markets Lack Direct Correlation With U.S. Stock Market

U.S. stocks represent only approximately 43% of the total value of global markets. International stocks represent an added opportunity for investors. In fact, many of the largest companies that make steel, electronics, and consumer appliances are based outside of the U.S. There are 16 major stock exchanges in the world that have a market capitalization of over $1 trillion. There are many opportunities that exist in rapidly growing economies outside of the U.S. and include companies with extraordinary rates of return.

From a portfolio management perspective, investing in foreign companies is one way to diversify an investment portfolio. For instance, U.S. and foreign shares do not always move in tandem with each other. When one stock market is up, the other may be down, and vice versa. In technical terms, such markets are said to lack correlation. A diversified portfolio balances uncorrelated assets to spread the risk.

Of course, that doesn't mean that U.S. and foreign shares always move in opposite directions. Many countries rely heavily on the U.S. for imports and exports and can be susceptible to market shifts in the U.S. Because of the interconnectedness of the global economy, stocks often move in the same direction, especially when the U.S. is experiencing a bear or bull market. Nevertheless, in the long-term, U.S. and foreign shares are sufficiently independent.

Risk Involved With International Stocks

However, investors should appreciate the serious risks involved with international stocks. The first risk to be aware of is exchange rate risk. A U.S. investor's return on a stock from a foreign country is tied to changes in the currency values between the U.S. dollar and that country's currency. If you buy a Japanese stock and the Japanese yen rises against the dollar between the time you buy and sell the stock, your return will be worth more. On the other hand, if the yen weakens, your investment return weakens.

In addition to upheavals in currency markets, there is also country risk when investing in international stocks. Many countries also suffer from political, social, and economic instability, which increases the risk of investing in their markets. Finally, performing due diligence before buying a security can be more challenging when the product is from another country. Foreign governments have different reporting and tax regulations for securities. In many cases, foreign companies are not required to provide the same detailed information that U.S. companies must provide, and overseas companies may use different accounting procedures, which can make an analysis trickier.

How to Buy Foreign Stocks

For investors with the patience to perform a thorough investigation, international stocks can offer big rewards. While many investors understand the rationale for investing abroad, they may be deterred by the mechanics of purchasing shares on a foreign exchange. Here are some strategies for investing in foreign companies.

American Depositary Receipts (ADRs)

American depositary receipts (ADRs) can help make foreign markets accessible for U.S. investors. ADRs are listed on the New York Stock Exchange (NYSE) and Nasdaq, and they can be traded, settled, and held as if they were ordinary shares of U.S.-based companies. Foreign companies with ADRs issue financial reports that generally conform to U.S. accounting conventions and the rules of the Securities and Exchange Commission (SEC). Companies with ADRs include Nokia (Finland), GlaxoSmithKline (United Kingdom), and Sony (Japan).

Although they trade on U.S. exchanges, ADRs still offer the benefits of diversification and ADR prices tend to behave like the foreign stocks they represent.

U.S.-Traded International Stocks

Some foreign stocks have met the listing requirements of either the New York Stock Exchange (NYSE) or Nasdaq and therefore are traded on U.S. markets.

U.S. Multinational Corporations

As an investor, it's also worth considering investing in domestic stocks with exposure to foreign markets because many U.S. companies generate the majority of their revenue from outside the U.S. Buying shares of U.S. multinational corporations can be an effective way for investors to get exposure to the global economy.

Foreign Stocks Are an Opportunity for Diversification

Because foreign markets lack a direct correlation with the U.S. stock market, investing outside the U.S. can be an effective way to diversify your portfolio. It can also expose you to risks associated with exchange rates, political or economic instability, and differences in reporting and tax regulations. However, the risks of accessing foreign markets through instruments such as ADRs, international stocks traded on U.S. exchanges, and by investing in U.S. multinational corporations can be worth the potential rewards for investors who have the patience to conduct a thorough investigation.