A key to secure investing includes having a diversified portfolio that is specifically allocated to differing investment types and sectors of the economy, a truth often referred to as not “putting all of your eggs in one basket.” One of the ways to diversify is by country or geographic region instead of just in the US economy. You may think that investing in the stocks and bonds of another country is extremely risky and limit your investments to the US as a result, but if you do that, you are overlooking the fact that when compared with the EU, Asia and the rest of the world, the US market is no longer the biggest market on earth. Ignoring foreign markets does limit the choices and opportunities for investment, so many investors take this into consideration and want to invest globally, not just locally.
The EU, Asia and Southeast Asia are very large global forces for commerce and offer many investment opportunities for serious investors. The rewards are sometimes significant, particularly when the economy of a country is growing. There are also risks, however. As an investor, it pays to be aware of the risks and weigh them against the potential rewards, as much as is possible.
Reducing risks begins with having a plan that has been crafted for the individual investor or organization in mind. This is also the starting point for the rewards that are possible with global investing. When one country is in recession, another may be experiencing solid growth. The poor returns or losses in one country can be offset by gains in another country. A carefully crafted financial plan and investment strategy will produce better long term investment returns while also managing the risks of investing by identifying and minimizing the potential rewards and the risks on a case by case basis for the specific goals and objectives of an investor.
With these basic concepts in mind, what are some of the risks associated with investing globally rather than just in the US?
Probably the most pervasive risk of investing in a foreign country is corruption. Corrupt governments allow and even encourage corrupt businesses. When this is the rule in a country, investment is very risky. Many early investors in Russia after the fall of the Soviet Union found themselves dealing with dishonest business owners, scam artists and gangsters rather than legitimate corporations and businesses. Corrupt governments pass laws, require bribes and make rules that favor their own cronies, pad their own pockets and enrich their own families and friends but do not offer much opportunity for outside investment. Corruption is a worldwide problem and a major deterrent for global investing.
Geopolitics is more recent risk for global investors. This is basically a risk of markets slowing down or reversing due to threats of military action and/or economic sanctions (Korea, Iran, others?) between the US and other nations, Currently, the threat of trade wars with China and even with our allies adds risk to a global portfolio. Some of the geopolitical risks of last year, such as the UK leaving the EU (Brexit) and failing economies, such as Greece, have now faded from importance, but they could rise again and do need to be monitored. Currently, the threat of trade wars appears to have the most potential for damage to the US economy and the markets in general. Some experts believe that trade wars can and will be avoided, but other experts are not so sure about this.
Another risk is the rising US dollar. When you buy stocks, for example, in a foreign country, those stocks are denominated in the currency of that country. Japanese stocks are denominated in yen, not dollars. You use US dollars to buy, however, so the currency exchange rate will affect your purchase and sale of those foreign shares. This can become complicated, of course. Mutual funds that invest overseas have the responsibility to track the currencies and do the exchanges for investors, but it adds to the cost of the fund to keep track of this complex piece of the management of funds invested globally.
In addition, when the dollar value is high compared to other currencies, goods and services from the US are more expensive. This has a direct effect on our economy by reducing the amount of goods and services that we sell to other countries. During 2017, the US dollar fell in value but in April of 2018, that trend reversed itself and the dollar rose sharply in value. The result is that investors who invest in foreign companies using US dollars experience a drop in their returns. Both of these factors are negatives that may impact the returns for US investors invested globally.
Some areas of the world are historically unstable, making them too risky for most investors to even consider. These are usually war torn countries, such as Syria and Yemen, but instability also follows in countries plagued by political corruption, which has included major economies in South America and Africa. Other countries are unsuitable for average and/or conservative investors because their banking systems are corrupt or their financial accounting systems are poorly regulated. Countries with these problems are not good choices for global investment. However, in many regions, there are pockets of stability and growth, creating micro economies with attractive investment opportunities. The risk in each of these is that the problems of the neighboring countries can and sometimes do spill over, spoiling the economies of the more stable countries. Serious investors should be very cautious about any investment in an economy that is experiencing new growth after recovery from war or corruption. It is worth noting that these countries, if they succeed in becoming stable, often grow so fast that investment returns are unusually good, but the risks are still considerable. Funds that include these geographic areas for investing are clearly rated as high risk by independent fund rating companies and are not suitable for the average investor. Investing globally does not have to include these areas, but they should be identified in any global investment strategy in order to be avoided.
Many investment experts have been concerned for several years about the potential for a rise in inflation. To date, it has not become a problem, but the risk is rising that inflation will go up sooner or later. Rising interest rates always have a negative effect on the bond market. When the US bond market is in decline or experiencing poor performance, investors seek out bonds from other countries, but bonds from other governments and foreign firms do not have the same degree of safety that US bonds often have, so they are sometimes much more risky than US bonds. When investors buy foreign bonds in an effort to find higher yields, supply and demand can and often does drive up the prices of those bonds, making them more expensive to purchase. This can also reduce the long term gains if/when those bonds are eventually sold.
So, global investors should be aware that when inflation begins to rise in the US, bonds all over the world will be impacted. Stocks can also be impacted when inflation rises. How much impact depends on the rate of increase in interest rates and the point at which inflation stops rising. The Federal Reserve Bank is intent on achieving an inflation rate goal that they believe is healthy for the US economy and markets, but it is a delicate balancing act, to be sure. The Fed has made it clear that they will raise the Fed interest rate twice before the end of this year 2018. In addition, the central banks of other countries have raised their own interest rates. According to government statistics, the US rate of wholesale inflation is now at 2.9% for the last 12 months, up from 2.1% for the prior 12 months. That is an increase of 38% in this inflation rate, and it is significant. Inflation is on the rise, has the potential to disrupt the growth in our economy and should not be ignored.
A final risk that you should avoid as a serious investor is a common one, and it occurs often in bull markets. This risk is a behavior that is called “chasing returns”. Investors can mistakenly believe that they should move their money around from whichever fund is the current top-performer to the next top-performer. They literally chase the funds with the best performance each year, thinking that it will result in better investment returns for their own portfolios. Generally, this does not work. It has been historically shown that the top fund one year often falls to the bottom of the list the next year or two.
Investors who chase returns jump into a sector such as tech stocks when they are up, then jump over to financial stocks when they are up, then jump to another sector when it is up, and so on. All they achieve is that they get in at the top and pay more for their shares, which ultimately reduces their returns, however. For global investors, chasing returns can mean jumping in and out of different countries or currencies, or geographic regions of the world in much the same manner as fund jumping or sector jumping. It is a foolish way to invest, but invariably appeals to some people during booming markets and/or growing economic cycles.
Does this mean that you should invest globally? Or does it mean that you should not? The answer is neither. Some of these risks are not limited to global investment; they are customary risks in any country. If you believe that you need the additional diversification that global investing provides, you should understand the risks and rewards. You can manage risk and you can also manage your expectations of reward by keeping your goals reasonable and suitable. The time-tested best method of managing investment risk is with a carefully crafted financial plan that utilizes asset allocation and diversification as the foundation of the investment strategy. Knowing as much as possible about the risks that exist and taking a long term view, without greed or fear as the guiding principal, increases the potential for good investment returns over time. Knowing that the markets cycle up and down and refusing to allow the ups and downs to deter you from the plan is the most important investment skill set to have. Not only does this kind of attitude and behavior reduce risks, it has been shown to improve returns over the long term. The combination of better returns at less risk is an ideal investment goal, in my opinion but it requires discipline and patience. This is a skill set that will prove your best characteristics if you want to avoid investment risks, get good returns and enjoy the benefits of being a successful global or local investor.
By Mary Lynne Dahl, CFP®