©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:
- 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.
- 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).
- 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.
- 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!
- 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.
- 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.
- 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?
- 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.
- 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.
- 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.