INVESTING IN INTERNATIONAL STOCKS

As noted in Chapter 8, the U.S. stock market amounts to only 40 percent of the world stock market, and as a result many U.S. investors hold at least some foreign stock. Analysts have long touted the benefits of investing overseas, arguing that foreign stocks both improve diversification and provide good growth opportunities. For example, after the U.S. stock market rose an average of 17.5
percent a year during the 1980s, many analysts thought that the U.S. market in the 1990s was due for a correction, and they suggested that investors should increase their holdings of foreign stocks.

To the surprise of many, however, U.S. stocks outperformed foreign stocks in the 1990s—they gained about 15 percent a year versus only 3 percent for foreign stocks. However, the Dow Jones STOXX Index (which tracks 600 European companies) outperformed the S&P 500 from 2002 through 2004. Table 9-2 shows how stocks in different countries performed in 2004. Column 2 indicates how stocks in each country performed in terms of the U.S. dollar, while Column 3 shows how the country’s stocks performed in terms of its local currency. For example, in 2004 Brazilian stocks rose by 25.12 percent, but the Brazilian real increased over 11 percent versus the U.S. dollar. Therefore, if U.S. investors had bought Brazilian stocks, they would have made 25.12 percent in Brazilian real terms, but those Brazilian reals would have bought 11.1 percent more U.S. dollars, so the effective return would have been 36.22 percent. Thus, the results of foreign investments depend in part on what happens to the exchange rate. Indeed, when you invest overseas, you are making two bets: (1) that foreign stocks will increase in their local markets, and (2) that the currencies in which you will be paid will rise relative to the dollar. For Brazil and most of the other countries shown in Table 9-2, both of these situations occurred during 2004.

Although U.S. stocks have generally outperformed foreign stocks in recent years, this by no means suggests that investors should avoid foreign stocks. Holding some foreign investments still improves diversification, and it is inevitable that there will be years when foreign stocks outperform domestic stocks, such as the period from 2002–2004. When this occurs, U.S. investors will be glad they put some of their money into overseas markets.

  • What are the key benefits of adding foreign stocks to a portfolio?
  • When a U.S. investor purchases foreign stocks, what two things is he or she hoping will happen?