Many people hold foreign investments as part of a diversified portfolio. The U.S. stock market can be volatile, but markets in other countries can fluctuate even more unpredictably. Here are a few risks of foreign funds you should be thinking about.
1. Volatility. If you think U.S. equities are volatile, be prepared for an even rockier ride. The United States, being the biggest economy of the world, also houses the most big cap stocks within its exchanges. The effect is that while stocks are volatile here, the waves are nowhere near as great as other countries.
2. Country specific risk. Every country can enact their own legislation that could affect stock prices. You don't live in those countries and probably won't know even when important events are unfolding.
3.Currency differences. The price of the currency as it relates to the U.S. dollar will also affect your investments in a big way. You could be buying all the right funds, but if the value of the currency in that country keeps dropping it will put a serious dent on your return. Here are four other ways to invest in foreign currencies.
4. Middle man complications. Most of us don't have access to a foreign market directly, so we rely on funds to provide foreign exposure. Fund managers visit companies they invest in. Just the travel expenses alone are higher because the companies are, well, farther away.
5. Sampling. Even index funds have risks. While funds try to track their respective indexes, the performances aren't exact.
6. Spread. If you invest in exchange traded funds, beware that some funds have large spreads, which means that the difference in price of buying and selling the fund is big. This isn’t a problem if you inherit shares that you plan to pass on to your heirs. But if you plan to sell the shares to pay for retirement it could be meaningful.
7. NAV Risks. Funds are bought or sold, so their current price may not always represent the value of all the assets they hold. Though it is expected that the price of the fund will generally reflect the net asset value (NAV), you may end up paying more than the NAV when you buy and get less than the NAV when you sell.
Why you still need foreign funds. The fact of the matter is that any investment carries risks. Though international investments may be more volatile and cost more to own in general, including them in your portfolio actually reduces your overall risk. It sounds weird, but that's the power of diversification.
There's no guarantee that the U.S. will still be the world's largest economy by the time we retire. If the U.S. is in a long term slump, our foreign exposures will cushion the fall. For example, the S&P 500 basically returned nothing in the past decade, but you would have tripled your money if you invested everything in emerging markets during the past 10 years. Holding international investments may be risky, but it could actually keep you sleeping better at night.
David Ning runs MoneyNing, a personal finance site aimed at helping others change their habits for a better financial future. He suggests that everyone to sign up for an online savings account to get more out of our hard earned money.