Foreign investments

In the past, making investments in foreign securities was difficult, but it’s a much easier task in today’s digital and instantaneous world. Many brokerage firms allow their customers to invest directly into foreign stocks and bonds, and nearly every firm provides an opportunity to invest in foreign securities through securities like mutual funds and ETFs. Regardless of the way it’s done, investing in foreign securities comes with unique benefits and risks.

A big benefit of foreign investing is diversification, which is an important aspect of investing. If you owned only one stock in your entire investment portfolio, you could lose everything if the company went bankrupt. To avoid this risk, investors tend to invest in numerous securities across different industries and regions. That way, there’s balance to a portfolio.

In 2018, the energy sector (natural gas, oil, etc.) was the worst performing sector, down more than 20% by the end of the year. If all of your money was invested in energy stocks, you would’ve lost a considerable amount of money. However, the health sector (pharmaceuticals, medical technology, etc.) was up over 4% over the year (2018 was not a great year in the stock market; in fact, the S&P 500 was down over 6%). By having some money invested in the health sector, losses from energy would be balanced out by the gains from health. This is diversification.

Foreign securities provide an opportunity for investors to diversify their investments. There have been many times in the past when domestic investments weren’t performing as well as foreign investments. If the US economy is going through a recession, losses could be balanced out by having exposure to some foreign investments.

Depending on the foreign investment, additional risks could exist. Foreign investments from countries with large and strong economies (like Japan or Germany) would generally be considered the safest forms of foreign investing. Investments from smaller, possibly third-world countries come with much more risk. Investments in companies or organizations from smaller, but growing foreign economies/countries are referred to as emerging markets.

Countries like Mexico, Thailand, and South Africa are considered emerging markets. While these countries haven’t historically been big players in the global economy, their economies are growing and gaining momentum. Investments in companies or organizations in emerging markets come with a substantial amount of risk. Many of these countries have governmental issues (corruption, “red tape,” etc.), economic problems, and weak infrastructure for business.

For example, Venezuela has a history of nationalizing businesses, meaning the government overtakes a private company and claims it as a public good. If you owned stock in a foreign company and it was nationalized, you could lose an immense amount of money and/or opportunity. You were the owner, but now the foreign government is. This is could be a risk when investing in emerging markets.

While these investments present a fair amount of downside risk, they also come with immense potential for profit. If investors can stomach the volatility that comes with emerging market investments, there’s a history of significant profits made off these investments. Plus, smaller economies have more room for growth, offering more opportunity to make profits.

Another risk of foreign investing involves currency. In order to invest directly in foreign companies and/or organizations, the currency must be converted. For example, investing directly in a Japanese company would require a conversion from the U.S. Dollar to the Japanese Yen. At the time of the conversion, the value of each currency can either work for or against the investor. You’ve probably heard of weak and strong currencies. Neither are considered universally “good” or “bad,” but each comes with consequences.

A weak currency can be beneficial or detrimental, depending on the circumstance. For example, a weak domestic currency would work against an investor if they’re investing in a foreign company. When a currency is weak, it means that it doesn’t buy as much of another foreign currency. Here’s a real-world example:

From June 2015 to November 2019, the US Dollar weakened against the Yen, meaning one US Dollar bought fewer yen in 2019 than it did in 2015. When this occurs, it’s more expensive to buy Japanese investments. Using these numbers, let’s assume an investment in a Japanese company cost 15,000 yen per share. Here’s the difference in price, with the only component changing being the exchange rate:

Even if the investment cost is the same in yen (¥15,000), the amount paid in US Dollars is more in 2019 due to the US Dollar weakening. This is an example of currency (exchange rate) risk, which occurs when a currency conversion negatively affects an investment. Here’s the math behind the numbers above:

June 2015

• $\frac{\text{¥15,000}}{\text{¥125 yen per\hspace{0.33em}USD}}$ = $120 per share

November 2019

• $\frac{\text{¥15,000}}{\text{¥110 yen per USD}}$ = $136 per share

A weak US Dollar works against American investors when purchasing a foreign investment. However, it works in their favor if they’re selling a foreign investment and converting back to US Dollars. If the investor sells the ¥15,000 Japanese investment, they would net $136 per share in November 2019, as compared to $120 per share in June 2015.

As we’ve demonstrated, a weak currency results in different outcomes depending on the circumstance. Here’s a summarization of these points:

Weak domestic currency

• Unfavorable converting into foreign currency
• Favorable converting out of foreign currency

Similar to a weak currency, a strong currency can be beneficial or detrimental, depending on the circumstance. From November 2011 to November 2019, the US Dollar strengthened against the Japanese Yen:

When the US Dollar buys more Yen, it’s less expensive to make a foreign investment. When the conversion from Dollars to Yen occurs, more Yen is obtained, allowing the investor to buy more of their Japanese investment.

In November 2019, a ¥15,000 investment cost $136 per share, which is dramatically cheaper than the $200 per share cost for the same ¥15,000 in November 2011. A strong currency is definitely favorable for buying foreign investments. Here’s the math behind the numbers above:

November 2011

• $\frac{\text{¥15,000}}{\text{¥75 yen per USD}}$ = $200 per share

November 2019

• $\frac{\text{¥15,000}}{\text{¥110 yen\hspace{0.33em}per USD}}$ = $136 per share

Of course, a strong currency has its downside. If you were to sell a foreign investment with a strong domestic currency, you receive less due to the conversion. Selling a ¥15,000 investment netted $200 per share in November 2011, versus netting $136 per share 8 years later in November 2019. This is another example of currency exchange risk.

Again, we’ve demonstrated a currency’s strength results in different outcomes depending on the circumstance. Here’s a summarization of the consequences of a strong currency:

Strong domestic currency

• Favorable converting into foreign currency
• Unfavorable converting out of foreign currency

Here’s a video that breaks down foreign currency risk further:

Series 7 test questions may involve foreign investments and currency strength. While foreign investments add to diversification, they also add a layer of complexity when involving currency conversions. Depending on the strength of the currencies involved, the investor may increase or decrease their overall return.