Ten Rules for the Global Investor

©2003 Investing Across Borders, LLC. All rights reserved.

Ten rules for the global investor

By Michael Molinski, Investing Across Borders

As appeared in the book, "The Global-Investor Book of Investing Rules." (Harriman House, 2008)

In spite of some recent gains, U.S. stocks are arguably still in a bear market. A short-term thing? Maybe. But what would happen to your investment portfolio if the U.S. market did nothing for the next five years? Or the next ten? It’s happened before. U.S. stocks actually declined in the decade from 1971 to 1981. And after the decade-long stock market boom of the 1990s, the timing seems precipitous for another long bear.

The possibility of a long-term bear market in the United States is just one of many reasons why investors should look to expand their portfolios overseas. Research has proven time and again that putting a portion of your portfolio overseas – anywhere from 10 to 40 percent – reduces your overall portfolio risk while boosting your potential for higher returns in the long run. And yet, U.S. investors fail to take heed. A whopping 90 percent of U.S. investment dollars remains in the United States, and the average U.S. investor holds just two domestic stocks in his or her portfolio.

What's more, U.S. stocks are so heavily researched by major investment banks that it's hard for a small investor to find bargains. Not so overseas, where price inefficiencies are more common.

If you’re just getting started in global investing, or if you’re looking to expand the international portion of your portfolio, here’s 10 rules to keep in mind when taking the plunge:

  1. Diversify. The golden rule for global investing. Diversification is why you’re going global in the first place. But it doesn’t stop there. Putting half your portfolio outside your home country doesn’t necessarily mean you’re sufficiently diversified. It’s important to split up your investments between different regions of the world, between developed countries and emerging markets, between different asset types, industries and investment styles.
  2. Pay attention to correlation. This follows from Rule #1, but it’s important enough to emphasize. Avoid investing in countries whose stock markets are closely correlated with each other. Look for stocks in countries that have low correlation coefficients (R-squared) relative to the market of your home country (assuming most of your portfolio is invested in your home country).
  3. Don’t ignore risk. Risk can be measured and quantified, either by looking at volatility (standard deviation), relative volatility (beta) or risk-return measures such as the Sharpe Ratio. Get to know these terms. Even if you don’t fully understand them, you can use them to compare potential investments. Understanding risk is especially important when investing outside your home country. Find out what risks your investments are subject to such as currency risk, political risk, or regulatory risk, and weigh them against the stock’s potential returns.
  4. Never forget why you picked a stock. In today’s volatile investing world, it’s easy to get caught up in rallies or get spooked in bear markets. But when you’re faced with the decision of whether or not to sell a stock, the most important question to ask yourself is, "Why did I pick it in the first place?" Do the reasons still hold water? If not, dump it!
  5. Don’t use currency hedges. It’s a natural assumption that when one invests in a country whose currency is prone to devaluation, you should consider buying currency futures or hedging your investments in similar ways. In most cases, though, that assumption is wrong. Your global investments are, in and of themselves, hedges against a downturn in your home country’s stock market. Besides, currency hedges are expensive and require constant monitoring and frequent transactions. Your time and money are better spent elsewhere.
  6. Look under rocks. One of the principal reasons for investing abroad is that markets in lesser-developed countries are less efficient. It’s easier to find stocks whose prices may not reflect all the information that is out there about that company. Perhaps the investor who most personifies this rule is Templeton’s Mark Mobius, who has spent his life digging up bargains in the far corners of the globe. We don’t all have his travel budget, but we can spend time combing the Web for bargains.
  7. Do your homework. The Internet has made it possible for an investor in Des Moines, Iowa or Toledo, Spain to research and invest in companies from Kuala Lumpur to Sao Paulo. You wouldn’t buy stock in a company down the street if you didn’t know something about what the company does, would you? The same goes for global investing. What does the company make? What are its financial fundamentals? Who manages it? Who are its major shareholders? What are its strategic advantages? Who is its competition?
  8. Exploit the small-investor advantage. It’s a myth that large investors have an advantage over small investors. Especially when investing in far-off places, small investors can have several benefits, many of them having to do with liquidity. Emerging market stocks, for example, are often so lightly traded that big pension funds and mutual funds won’t spend the time researching and investing in them. Institutional investors also tend to put limits on the "high-risk" portion of their portfolios. And in times of crisis, it’s much more difficult for a big pension fund to sell off its $10 million stake in that Chinese cement company than it is for Joe Smith to sell off his $10,000 stake.
  9. Buy commodities, bonds, real estate, etc. Don’t limit yourself to equities when investing abroad. Alternative assets such as private equity, bonds, commodities, real estate, and others are an important part of a global portfolio just as they are domestically. Global bonds, for example, can diversify your fixed-income portfolio, and can bring much higher yields than the bonds of U.S. or major European countries – sometimes without a significant amount of added risk. Price inefficiencies also exist in the bond market, and investors willing to do their homework can find bargains in emerging market bonds. And commodities, better known as just "stuff," can often be a better way than equities to invest in resource-rich emerging markets.
  10. Buy mutual funds and exchange-traded funds. I’m a big believer in mutual funds, both in indexed products and in professionally managed portfolios. If you don’t have the time and energy to spend researching global stocks, let someone else pick them for you. Your costs will almost invariably be lower than if you tried to build your own portfolio of global stocks. In picking funds, though, be sure to pay attention to costs, tax implications, risk and the track record of both the fund and its managers. Spread the foreign portion of your portfolio across more than one fund. For example, you might buy three funds: a broad-based international fund, a regional fund in an area of the world that you believe will outperform, and an emerging markets fund. Additionally, one of the best new investment products for small investors are exchange-traded funds, or ETFs. These instruments resemble index funds but trade like stocks, and carry the same transaction fees. They are linked to baskets of stocks in given countries or regions, and their management fees are miniscule compared to most mutual funds.

Stick to these ten rules when going abroad, and it’d be hard to go wrong. Remember, diversity and holding for the long term are the keys to global investing. Make risk your friend, not your enemy. And, by all means, do your homework, even if you plan to buy international mutual funds.

The SEC's Tutorial on Asset Allocation

Beginners' Guide to Asset Allocation, Diversification, and Rebalancing

Even if you are new to investing, you may already know some of the most fundamental principles of sound investing. How did you learn them? Through ordinary, real-life experiences that have nothing to do with the stock market.

For example, have you ever noticed that street vendors often sell seemingly unrelated products - such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never - and that's the point. Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items- in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.

If that makes sense, you've got a great start on understanding asset allocation and diversification. This publication will cover those topics more fully and will also discuss the importance of rebalancing from time to time.

Let's begin by looking at asset allocation.

Asset Allocation 101

Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.

Time Horizon - Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager's college education would likely take on less risk because he or she has a shorter time horizon.

Risk Tolerance - Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. In the words of the famous saying, conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush."

Risk versus Reward

When it comes to investing, risk and reward are inextricably entwined. You've probably heard the phrase "no pain, no gain" - those words come close to summing up the relationship between risk and reward. Don't let anyone tell you otherwise: All investments involve some degree of risk. If you intend to purchases securities - such as stocks, bonds, or mutual funds - it's important that you understand before you invest that you could lose some or all of your money.

The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals.

Investment Choices

While the SEC cannot recommend any particular investment product, you should know that a vast array of investment products exists - including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds, money market funds, and U.S. Treasury securities. For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Let's take a closer look at the characteristics of the three major asset categories.

Stocks - Stocks have historically had the greatest risk and highest returns among the three major asset categories. As an asset category, stocks are a portfolio's "heavy hitter," offering the greatest potential for growth. Stocks hit home runs, but also strike out. The volatility of stocks makes them a very risky investment in the short term. Large company stocks as a group, for example, have lost money on average about one out of every three years. And sometimes the losses have been quite dramatic. But investors that have been willing to ride out the volatile returns of stocks over long periods of time generally have been rewarded with strong positive returns.

Bonds - Bonds are generally less volatile than stocks but offer more modest returns. As a result, an investor approaching a financial goal might increase his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds would be attractive to the investor despite their lower potential for growth. You should keep in mind that certain categories of bonds offer high returns similar to stocks. But these bonds, known as high-yield or junk bonds, also carry higher risk.

Cash - Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories. The chances of losing money on an investment in this asset category are generally extremely low. The federal government guarantees many investments in cash equivalents. Investment losses in non-guaranteed cash equivalents do occur, but infrequently. The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time.

Stocks, bonds, and cash are the most common asset categories. These are the asset categories you would likely choose from when investing in a retirement savings program or a college savings plan. But other asset categories - including real estate, precious metals and other commodities, and private equity - also exist, and some investors may include these asset categories within a portfolio. Investments in these asset categories typically have category-specific risks. Before you make any investment, you should understand the risks of the investment and make sure the risks are appropriate for you.

Why Asset Allocation Is So Important

By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family's summer vacation.

How to Get Started

Determining the appropriate asset allocation model for a financial goal is a complicated task. Basically, you're trying to pick a mix of assets that has the highest probability of meeting your goal at a level of risk you can live with. As you get closer to meeting your goal, you'll need to be able to adjust the mix of assets.

If you understand your time horizon and risk tolerance - and have some investing experience - you may feel comfortable creating your own asset allocation model. "How to" books on investing often discuss general "rules of thumb," and various online resources can help you with your decision. For example, although the SEC cannot endorse any particular formula or methodology, the Iowa Public Employees Retirement System offers an online asset allocation calculator. In the end, you'll be making a very personal choice. There is no single asset allocation model that is right for every financial goal. You'll need to use the one that is right for you.

Some financial experts believe that determining your asset allocation is the most important decision that you'll make with respect to your investments - that it's even more important than the individual investments you buy. With that in mind, you may want to consider asking a financial professional to help you determine your initial asset allocation and suggest adjustments for the future. But before you hire anyone to help you with these enormously important decisions, be sure to do a thorough check of his or her credentials and disciplinary history.

The Connection Between Asset Allocation and Diversification

Diversification is a strategy that can be neatly summed up by the timeless adage "Don't put all your eggs in one basket." The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.

Many investors use asset allocation as a way to diversify their investments among asset categories. But other investors deliberately do not. For example, investing entirely in stock, in the case of a twenty-five year-old investing for retirement, or investing entirely in cash equivalents, in the case of a family saving for the down payment on a house, might be reasonable asset allocation strategies under certain circumstances. But neither strategy attempts to reduce risk by holding different types of asset categories. So choosing an asset allocation model won't necessarily diversify your portfolio. Whether your portfolio is diversified will depend on how you spread the money in your portfolio among different types of investments.

Diversification 101

A diversified portfolio should be diversified at two levels: between asset categories and withinasset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you'll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.

One of way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. But the stock portion of your investment portfolio won't be diversified, for example, if you only invest in only four or five individual stocks. You'll need at least a dozen carefully selected individual stocks to be truly diversified.

Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset category through the ownership of mutual funds rather than through individual investments from each asset category. A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, and other financial instruments. Mutual funds make it easy for investors to own a small portion of many investments. A total stock market index fund, for example, owns stock in thousands of companies. That's a lot of diversification for one investment!

Be aware, however, that a mutual fund investment doesn't necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. If you invest in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get the diversification you seek. Within asset categories, that may mean considering, for instance, large company stock funds as well as some small company and international stock funds. Between asset categories, that may mean considering stock funds, bond funds, and money market funds. Of course, as you add more investments to your portfolio, you'll likely pay additional fees and expenses, which will, in turn, lower your investment returns. So you'll need to consider these costs when deciding the best way to diversify your portfolio.

Options for One-Stop Shopping - Lifecycle Funds
To accommodate investors who prefer to use one investment to save for a particular investment goal, such as retirement, some mutual fund companies have begun offering a product known as a "lifecycle fund." A lifecycle fund is a diversified mutual fund that automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future, known as its "target date." A lifecycle fund investor picks a fund with the right target date based on his or her particular investment goal. The managers of the fund then make all decisions about asset allocation, diversification, and rebalancing. It's easy to identify a lifecycle fund because its name will likely refer to its target date. For example, you might see lifecycle funds with names like "Portfolio 2015," "Retirement Fund 2030," or "Target 2045."

Changing Your Asset Allocation

The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you'll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.

But savvy investors typically do not change their asset allocation based on the relative performance of asset categories - for example, increasing the proportion of stocks in one's portfolio when the stock market is hot. Instead, that's when they "rebalance" their portfolios.

Rebalancing 101

Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may become out of alignment with your investment goals. You'll find that some of your investments will grow faster than others. By rebalancing, you'll ensure that your portfolio does not overemphasize one or more asset categories, and you'll return your portfolio to a comfortable level of risk.

For example, let's say you determined that stock investments should represent 60% of your portfolio. But after a recent stock market increase, stock investments represent 80% of your portfolio. You'll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to reestablish your original asset allocation mix.

When you rebalance, you'll also need to review the investments within each asset allocation category. If any of these investments are out of alignment with your investment goals, you'll need to make changes to bring them back to their original allocation within the asset category.

There are basically three different ways you can rebalance your portfolio:

  1. You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories. 
  2. You can purchase new investments for under-weighted asset categories. 
  3. If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.

Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger transaction fees or tax consequences. Your financial professional or tax adviser can help you identify ways that you can minimize these potential costs.

Stick with Your Plan: Buy Low, Sell High - Shifting money away from an asset category when it is doing well in favor an asset category that is doing poorly may not be easy, but it can be a wise move.  By cutting back on the current "winners" and adding more of the current so-called "losers," rebalancing forces you to buy low and sell high.

When to Consider Rebalancing

You can rebalance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing.

Others recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you've identified in advance. The advantage of this method is that your investments tell you when to rebalance. In either case, rebalancing tends to work best when done on a relatively infrequent basis.

Where to Find More Information

For more information on investing wisely and avoiding costly mistakes, please visit the Investor Information section of the SEC's website. You also can learn more about several investment topics, including asset allocation, diversification and rebalancing in the context of saving for retirement by visiting FINRA's Smart 401(k) Investing website as well as the Department of Labor's Employee Benefits Security Administration website.

You can find out more about your risk tolerance by completing free online questionnaires available on numerous websites maintained by investment publications, mutual fund companies, and other financial professionals. Some of the websites will even estimate asset allocations based on responses to the questionnaires. While the suggested asset allocations may be a useful starting point for determining an appropriate allocation for a particular goal, investors should keep in mind that the results may be biased towards financial products or services sold by companies or individuals maintaining the websites.

Once you've started investing, you'll typically have access to online resources that can help you manage your portfolio. The websites of many mutual fund companies, for example, give customers the ability to run a "portfolio analysis" of their investments. The results of a portfolio analysis can help you analyze your asset allocation, determine whether your investments are diversified, and decide whether you need to rebalance your portfolio.

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Questions or Complaints?

We want to hear from you if you encounter a problem with a financial professional or have a complaint concerning a mutual fund or public company. Please send us your complaint using our online Complaint Center. You can also reach us by regular mail at:

Securities and Exchange Commission
Office of Investor Education and Advocacy
100 F Street, N.E. 
Washington, D.C. 20549-0213

Modified Aug. 28, 2009