While the U.S. market remains the world's largest (in terms of dollar value), markets in developed and emerging market countries have gained ground. In fact, in the late 1980s, Japan's stock market temporarily eclipsed that of the U.S. in terms of size. In 2016, foreign markets represented 61% of the world's investment opportunities. Analysts project that by 2030, the U.S. stock market will represent just 34% of the world market.1
Diversification and higher returns
Because international markets do not always move in sync, diversification on a global scale may help offset the effect of a downturn in the U.S. market. A stock portfolio allocated 80% to U.S. stocks and 20% to international stocks, rebalanced annually, has historically earned slightly higher average annual returns than a purely domestic portfolio, with less variability in returns.2 Investors in international securities may face additional risks, such as higher taxation, less liquidity, political problems, and currency fluctuations, that do not affect domestic investors. But despite these risks, the potential for higher returns can make these markets attractive to many client portfolios.
The MSCI EAFE (Europe, Australasia, Far East) Index, which tracks 21 major world markets, posted a 5.95% annualized rate of return for the 30 years ended December 31, 2016, compared with the 10.16% annualized return of Standard & Poor's Composite Index of 500 Stocks (S&P 500).3 This difference in returns is due in part to differences in economic and market environments in countries around the world. For example, the Japanese market throughout the 1990s was depressed due to the country's economic recession. Many Japanese stocks became undervalued, providing a buying opportunity. In 1999 the Japanese stock market bounced back, producing a gain of more than 60%.
How to invest in foreign equities
One way to include international exposure in a portfolio is to invest in stocks of U.S. companies that derive a large portion of their annual revenue from overseas markets -- multinational companies like Coca-Cola or McDonald's.
Another way to invest internationally is through American Depositary Receipts (ADRs) -- traded on the New York Stock Exchange. ADRs are negotiable certificates that represent the shares of a publicly-traded foreign company. ADRs are issued in the United States and their underlying shares are held in U.S. banks.
An even easier way to invest internationally may be to buy shares of broadly diversified international mutual funds, which invest exclusively overseas, or global funds, which may buy a mix of foreign and U.S. stocks. These types of funds offer instant diversification in an array of foreign market stocks.
For more experienced and more aggressive clients wishing to target stocks in particular regions or countries, regional or country funds are also available. These funds are designed to take advantage of specific opportunities in the world's developed and emerging markets, but they do carry an increased risk of volatility.
Special risks of international investing
It is important to let clients know that international investing does present unique risks and considerations. A U.S. investor's foreign-investment return depends on both the local currency's exchange value against the U.S. dollar and the stock price in the local currency. For example, falling currency values and plummeting stock prices in Asian nations in 1998 drove down stock prices not only for international investors in Asia but also for those in the United States because many American companies depend on Asia for customers. For U.S. investors, currency losses could also stem from a rise in the dollar's value against the currency of the foreign country they are investing in. In the past, currency fluctuations have tended to balance out over extended periods of time, although there are no guarantees this will always be the case.
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1 Market-share data is from the World Federation of Exchanges. Estimate for 2030 is based on the rate of growth of non-U.S. markets vs. the U.S. since 1975. Past performance is not a guarantee of future returns.
2 For the period from January 1, 1977, through December 31, 2016. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
3 The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. The EAFE is an unmanaged index generally considered representative of the international market. Index performance is not indicative of the performance of a particular investment, and past performance does not guarantee future results. Individuals cannot invest directly in any index.