Offshore investing: spreading risk helps sleep

The worlds economies still dance to different tunes and have different boom and bust cycles that tend to offset each other, even though the differences are getting smaller. As a result, international stocks can provide diversification for a portfolio heavy in U.S. stocks.

Between June 1997 and October 1998, for example, Japans Nikkei index lost almost 40%, but European markets did well due to continental economic union. U.S.-style corporate restructurings also began to pay off. One regions success balanced the others failure to get its financial house in order.

There has been less divergence between regions more recently. Even so, we suggest the prudent investor cannot afford to ignore overseas markets. They now represent some 44% of world market capitalization, up from 25% about 30 years ago. International stocks can provide solid diversification for a portfolio heavily invested in U.S. equities.

Exchange rates add an extra flavor to foreign investments. Fluctuations can add to or detract from profits or losses. Institutional investors and others pay significant attention to this factor. When the U.S. dollar was appreciating against the Japanese yen, billions of dollars flowed out of that country and into U.S. stocks and bonds, worsening the economic crisis in Japan. That money started to flow back out when the currency valuation began to reverse. Americans saw their investments in Japan appreciate then, even when the stocks remained in neutral.

Funds that invest overseas fall into four basic categories: world, international, emerging market and country specific. Diversification is the key to containing risk. And, yes, a good fund manager helps, too. Research is scarce and foreign companies, other than some in Canada, are difficult for individual investors to track on their own.

World funds are the most diverse of the four categories. They are, as the name suggests, able to invest anywhere in the world, including the U.S. As a result, they dont offer as much diversification as a good international fund. Some have 60% or more of their holdings in the U.S.

World funds tend to be the safest foreign stock investments, but only because they typically lean on better-known U.S. stocks. Just examine the portfolio carefully to make sure they dont mimic your U.S. holdings. Funds invested in small- to medium-sized companies are unlikely to duplicate the foreign investment component of domestic funds.

Foreign funds, on the other hand, invest mostly outside the U.S. Whether they are relatively safe or risky depends on the countries in which they invest.

Advice: choose a fund with the best balance between countries and regions, or be very sure the manager has a good record of moving in and out of regions profitably.

Country-specific funds invest in a single country or region. This type of concentration makes them particularly volatile especially those that invest in emerging markets. If you pick the right country at the right time, the returns can be substantial. Get it wrong and look for your head to be handed to you on a plate. These funds are for the most sophisticate investors only.

Emerging-markets funds are the most volatile, invested as they are in undeveloped regions subject to political upheaval, currency risk and corruption. These economies, such as Argentinas in 2002, can collapse; governments can fall or be overthrown. On the other hand, these regions have enormous growth potential. Adding a small sprinkling of emerging markets exposure to your portfolio could serve to lessen downturns in U.S. markets but they are for long-term investors only, those who can wait for fallen markets to recover.

As always, of course, the biggest risks carry the greatest potential for outstanding rewards; you simply require nerves of steel. The best course is to diversify well and sleep soundly at night.