Investing in foreign stocks entails unique risks that differ from investing in public companies in the United States. These risks should be carefully considered and factored into investment decisions, and investors should seek a higher potential return to compensate for these added risks. Many U.S. investors apply basic analysis techniques learned in the U.S. market to evaluate foreign company investment opportunities, but this approach may not be sufficient.
There are various ways to approach investing in overseas markets, including broad international portfolios, portfolios focused on emerging or developed markets, specific regions like Latin America or Europe, or specific countries such as China. However, before diving into these opportunities, it is important to understand the risks involved.
One key risk to consider is economic risk. It is essential to assess whether a country has a solid balance sheet that ensures it can meet its debt obligations. Factors such as economic growth, lack of excessive debt, natural resources, an educated workforce, and a government that promotes investment and competition contribute to financial stability.
Political risk is another crucial consideration. Investors must have a good understanding of the government’s priorities and policies. It is essential to evaluate whether the political climate is conducive to running a successful business and achieving profitability. Additionally, assessing the future of the government and its policies is equally important. Instability caused by a discontented citizenry or powerful external groups can significantly impact investment decisions.
Sovereign risk mainly applies to bonds rather than stocks and may be too complex for average investors to evaluate thoroughly. However, it is worth mentioning because it represents a real risk. Factors such as the nature of the central bank, its policies, and regulations regarding foreign exchange play a role in evaluating potential bond investments.
To assess a country’s ability to repay its debt, credit ratings from reputable agencies like Moody’s and Standard & Poor’s are available. Additionally, reliable sources like the New York Times, Wall Street Journal, Financial Times, and The Economist provide extensive coverage of economic and political climates in foreign countries.
Currency risk is another factor to consider. Fluctuations in currency exchange rates can impact the value of investment returns when converted back into U.S. Dollars. This can result in additional gains or losses solely based on the strength or weakness of the U.S. Dollar against the foreign currency.
A real-life example of the risks associated with investing in foreign stocks is George’s experience with Alibaba. George, an MBA, CFA, and experienced investor, followed the advice of well-known investors like Charlie Munger and Ray Dalio who recommended investing in China and emerging markets. However, George neglected to consider the shift in China’s political climate under current leader Xi Jinping, who favored a more state-controlled economic model.
As a result, Alibaba faced challenges as the state oversight hindered its growth potential and competitive advantage. Other high-flying China stocks also suffered, except for Charlie Munger’s investment in BYD, a Chinese electric vehicle company. The chart below illustrates the performance of these stocks over a five-year period.
[Insert chart illustrating performance of China stocks]
Understanding these risks is crucial for determining the necessary return to compensate for them. While investing in foreign companies can be lucrative, thorough research on both risks and rewards is essential for making informed decisions. The more information investors have, the better they can manage overall risk. Investing intelligently overseas also improves the diversification of investment portfolios.
In conclusion, investing in foreign stocks carries unique risks that must be carefully considered. Economic risk, political risk, sovereign risk, and currency risk are all factors that can impact investment outcomes. By understanding these risks and conducting thorough research, investors can make informed decisions and potentially benefit from diversifying their portfolios with international investments.
