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Foreign stocks can be a good addition to your portfolio, as they can help you hedge against foreign exchange rates and get exposure to countries whose economies are growing faster than our own. Rather than buying individual foreign stocks, however, most investors choose to get foreign stock exposure through mutual funds or ETFs.
Why invest in foreign stocks?
There are a few compelling reasons that all stock investors should put some of their money into the stocks of foreign companies.
The No. 1 reason for investing in foreign stocks is diversification. You're probably familiar with the concept of diversifying your investments. For example, you shouldn't put 100% of your money in bank stocks because any financial sector weakness could be devastating to your portfolio. Similarly, it's not a great idea to be 100% reliant on one geographical area, as any localized weakness or economic turbulence could be devastating.
Investing in foreign stocks diversifies your currency exposure as well. For example, let's say that the value of the U.S. dollar drops by 50% against the Euro. If 100% of the companies you invest in earn dollar-denominated revenue, you'll get crushed. On the other hand, if a substantial portion of your portfolio does business in other currencies, the impact is likely to be much less.
Also, some of the world's best brands are based outside of the U.S. and aren't listed on major U.S. stock exchanges (Nestle and Nissan are excellent examples). Why just invest in U.S. food companies or car manufacturers, when you could invest in the best from around the world?
Because of inverse currency relationships (U.S. goes up, foreign currencies go down), as well as certain other factors, U.S. stocks and foreign stocks tend to make up for each other's performance weaknesses, which can actually produce better investment returns over time. In fact, Fidelity found that a 100% U.S. stock portfolio would have produced 11.3% annualized returns over the past 50 years, while 100% of foreign stocks would have returned 10.9%. However, a 70%/30% blended U.S. and foreign portfolio would have beaten both, with 11.4% average annual returns.
Finally, many foreign economies are growing at a faster rate than the U.S., so investing internationally allows you to take advantage of this. Specifically, countries known as emerging markets have significantly higher growth potential, so investing in stocks based in these countries could produce strong gains if things go well.
The best way to invest in foreign stocks (for most people)
Choosing foreign stocks can be difficult and risky, especially when it comes to emerging markets. Many of these companies can be difficult to analyze, and it's always difficult to pick long-term winners in undeveloped economies.
For this reason, the majority of U.S. investors are better off getting their foreign stock exposure through mutual funds or ETFs. This ensures that your foreign holdings are diversified, so your investment performance won't be too reliant on any single foreign company.
It's also important to mention the difference between foreign, international, and global stock funds. If a fund is labeled as "foreign" or "international," it generally invests its assets exclusively in non-U.S. companies. On the other hand, a "global" or "world" stock fund invests in countries all over the world, including the U.S.
A sampling of foreign stock ETFs worth a look
I generally prefer ETFs to mutual funds for their instant trade execution and lower share prices, so here's a list of eight of my favorite foreign stock ETFs, listed in no particular order. If you prefer mutual funds, or are investing through a 401(k), you can generally find funds that achieve the same objectives as these.
How much should you invest in foreign stocks?
It depends on your risk tolerance. While it does add diversification to your investments, foreign markets can be more volatile than the U.S., especially when it comes to emerging markets. As a general rule, I suggest allocating between 15% and 30% of your portfolio to high-quality international ETFs like the ones mentioned here. If you have a lower risk tolerance, stick to the lower end of this range, and if you can stomach a little extra risk, allocate a little more to your foreign holdings.
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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Nestle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.