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Investing in foreign stocks

By David Luhman on Sun, 05/10/2009 - 00:50

Investing in foreign stocks

Foreign stocks reduce risk and increase gains

As you probably can tell I'm a conservative investor who believes it's difficult to beat the market averages. However, in one respect, I'm somewhat unorthodox because I'm more willing to invest overseas than many other people.

There are two good reasons to place some of your equity investments overseas : lower risk and higher return.

If you think that this combination is impossible to come by, remember the benefits gained by diversification which I discuss in depth in my tape on mutual funds. Back in the 1960s the US stock market was by far the world's largest stock market, but today US stocks represent only about a third of the value of the world's stocks.

By diversifying into foreign markets, you can take advantage of the higher growth rates available in many countries, while protecting yourself against a downturn in the US economy.

Place 20 percent of equities overseas

Studies have shown that, compared with a US-only stock portfolio, a mixture of about 20 percent foreign stocks and 80 percent US stocks will increase your total annual return from about 10 percent to 12 percent while reducing the overall volatility of your stock portfolio.

The reason for this is simple. Over the past 20 years countries like Japan have had stock markets that have outperformed the US stock market by a wide margin. Throw in the fact that the Japanese currency has tripled in value against the dollar, and you've got a strong case for diversifying overseas.

Plus, when you account for the fact that the Japanese and American stock markets are not perfectly synchronized, you have the potential for lower volatility in your stock portfolio.

So although I recommend that you consider investing perhaps 20 percent of your stock investments overseas, I don't think you'll gain much by diversifying your bond investments overseas.

This is because foreign bond income usually is taxed by the overseas government. You can claim a credit for this tax on your US return, but not if you're investing through a retirement account. Also, bonds are inherently less volatile, so you don't reduce your risk much by investing overseas.

Because stocks are more volatile, and offer higher returns, investing in overseas equities looks more attractive. Plus, investing in foreign stocks doesn't lose you much in the way of taxation because many foreign countries have no capital gains taxes, and you can defer any foreign taxes by not selling and thus not realizing any gains.

Although I recommend that you invest some of your stock portfolio overseas, this should be done through a mutual fund. The fund offers professional management of an international portfolio which would be hard to replicate yourself.

Finally, if you do invest in overseas stock markets, try to find markets that aren't correlated with the US market. For example the Canadian and British stock markets tend to move in tandem with the US market, while the German and Japanese markets are more out of synch with the US economy.