Why Invest Internationally?

July 24, 2012
by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key points

• Some investors shy away from international investing believing it's too risky or complicated.
• We'll show you how it can lower your overall risk while potentially boosting your returns.
• ETFs and mutual funds can make international investing convenient.

A young, educated workforce in Singapore. Rising household income in Brazil. Export growth in China. Natural resources in Canada, Australia, Brazil and Norway.

These are some of the factors driving global growth. And if you're only investing in US companies, they represent opportunities you may be missing. In fact, investing solely in the United States amounts to excluding three-fourths of the global economy¹ and over half of the world's stock market value.²

We believe that allocating between 5% (conservative) to 25% (aggressive) of your total portfolio to international stocks can be a smart move for a number of reasons:

• Potential for higher rates of growth abroad.
• International stocks are becoming a larger share of the investment universe.
• Potential to lower overall risk in your portfolio.
• Multiple currencies can provide an added layer of diversification.

Let's look closer at each of these.

High rates of growth abroad

International markets can offer growth opportunities that may not be available in the United States due to differences in household income, younger populations, availability of natural resources, export strength, and movement toward free-market economic policies. Many Asian countries, for example, benefit from exports to the Chinese economy.

Exposure to these unique growth areas, as well as emerging markets, can boost return potential. Emerging market countries typically have lower household incomes and lower debt levels relative to developed markets, giving them the ability to grow faster.

Economic growth in the United States is expected to be subdued in the near term. The International Monetary Fund (IMF) is forecasting growth in the United States to be below world growth over the next several years.³

Emerging-market economies in particular are expected to have high growth rates which the IMF estimates are two to three times faster than developed-market economies.⁴ Corporate revenues have the potential to grow faster when economic growth is higher. However, bottom-line profits depend on how expenses grow. For example, wages in China have continued to rise this year, despite the slowdown in revenue growth.

United States becoming a smaller share of the pie

In addition, while the United States boasts the world's largest economy and stock market, the country's importance and share of the world economy has been declining, particularly as emerging markets have grown in size. Remember, investing solely in US stocks means excluding nearly three-fourths of the global economy and over half of the world's stock market value.

While it's true that US companies can have international operations, investing in companies located overseas provides the potential to benefit from currency diversification (more below).

Potential to lower overall risk in your portfolio

Investors can potentially reduce portfolio risk by diversifying their investments across various asset classes—categories of investments—each tending to respond differently to various market cycles and events. International stocks are one of the five main asset classes, along with large-cap stocks, small-cap stocks, bonds and cash investments. While international investing has higher stand-alone risk, the power of diversification across asset classes can potentially lower your overall portfolio risk.

Put simply, by investing abroad you gain exposure to companies operating in other countries—with potentially unique products and customer sets—that may weather market downturns and upturns differently.

See the table below, which shows how performance in the United States has stacked up versus other developed markets in recent years.

The Best And Worst Performing Markets

Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Based on developed markets as designated by MSCI® as of 12/31/2011. Each market, except the U.S., is represented by annual total returns of the MSCI country index and is net of taxes. The S&P 500® Index represents the U.S. market's annual total returns. Returns assume reinvestment of dividends and interest. All returns are in U.S. dollars. International investing may involve greater risk than U.S. investments due to currency fluctuations, unforeseen political and economic events, and legal and regulatory structures in foreign countries. Such circumstances can potentially result in a loss of principal. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

Also, take a look at the graph below. It shows how a hypothetical portfolio of 75% domestic stocks and 25% international stocks delivered a higher return with lower risk than an investment in either market alone from 1971-2011.

International Investing Adds Diversification, Potentially Improving Overall Return and Risk

Source: Schwab Center for Financial Research with data from Morningstar Inc. United States represented by Dow Jones U.S. Total Stock Market Index. International represented by MSCI EAFE Index net of taxes. The 75/25 hypothetical portfolio is rebalanced monthly with dividends and capital gains reinvested, excluding transaction costs. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. MSCI EAFE is the measure of the equity market performance of the developed markets of Europe, Australasia, and Far East. Time period is from January 1971 to December 2011. Risk is measured by the annualized standard deviation of monthly returns.

Currency: An added layer of diversification

An important benefit of international investing is exposure to currencies other than the US dollar, another way investors can diversify their portfolios.

One of the key factors affecting returns is how currencies behave in relation to other countries. And because currencies tend to move in different directions, when the US dollar is declining, investments in international companies can help boost returns. Of course, the reverse is also true—when the dollar goes up, international investments tend to underperform.

These relative currency moves are a significant reason the best-performing market varies from country to country each year (see table above).

Know the risks of international investing

Investing internationally also brings increased risks. However, the good news is that many of these risks are reduced if you hold a diversified (by country, sector and company) portfolio of international stocks, such as many international mutual funds and ETFs provide.

What to keep in mind:

• Political and regulatory risk. Foreign governments can be less stable and they can have restrictions on how freely businesses operate as well as their ability to earn profits. Also, a country's financial condition can undercut growth prospects. For example, if a country is running large deficits, it may need to raise taxes and reduce spending, which could shrink corporate profits.
• Information risk. Finding timely and accurate information about your investments may be more difficult, and there can be differences in accounting standards. This can make comparisons to US companies challenging. An additional consideration is that news about international companies can occur at nearly anytime, impacting price movements during times that are inconvenient for US-based investors.
• Currency risk. There's the possibility that the currency of your investment will fall relative to the US dollar, lowering the return after it's translated back into dollars.
• Transaction risk. Some countries impose currency controls that restrict or delay currency conversion, prolonging the time until you are able to access your funds. Reporting, clearing and settlement of trades also may take longer.
• Higher volatility of returns. International markets can be more volatile and trading can be less liquid (fewer shares changing hands). Dollar-cost averaging—investing a fixed dollar amount at regular intervals—can be a good tactic to spread out risk and lower the average cost per share.
• Higher costs. Investing directly on foreign exchanges can bring additional fees, including higher commission costs, exchange fees, stamp duties, transaction levies and foreign currency fees. These fees are the reason most international mutual funds and ETFs cost investors a bit more (via higher expense ratios) than their domestic counterparts.

Bottom line

International markets are gaining in importance, and by investing solely in the United States, you may be passing over growth opportunities. While there are higher risks involved with international investing, by adding it to your other investments, your overall portfolio risk could decrease while experiencing potentially higher returns—making it well worth your time to add some international flavor to your portfolio.

1. The International Monetary Fund, December 2011.

2. S&P Global Broad Market Index, May 2012.

3. International Monetary Fund, April 2012.

4. International Monetary Fund, April 2012.

Important Disclosures

For funds, investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Some specialized funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

International investments are subject to additional risks such as currency fluctuation, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Diversification strategies and dollar-cost averaging strategies do not assure a profit and do not protect against losses in declining markets.

Past performance is no guarantee of future results.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.