International Diversification Should Not Be Done Blindly

The Wall Street Journal had two bits on international diversification: a poll and an article. Both were good as far as they went, but the past outperformance of international over domestic stocks doesn’t help us analyze which will be better in the future. That macro question is hard, particularly because once a streak gets long, it gets more touchy to be long. But let’s look at a “micro” angle on foreign investing.

One of the reasons to invest abroad is to diversify currency risk. Let’s pretend for a moment that we know the dollar is going down over the next few years. What stocks would I buy? I would buy foreign companies that import US goods (costs are getting cheaper), foreign companies that are purely local (earnings stream rising in dollar terms), and US companies that export (sales should rise as the dollar falls).

Now let’s pretend for a moment that we know the dollar is going up over the next few years. What stocks would I buy? I would buy foreign companies that export goods to the US (sales should rise as the dollar rises), US companies that are purely local (earnings stream rising in foreign currency terms), and US companies that import (costs are getting cheaper).

All that said, foreign investing is more complex because of:

Expropriation risk

Different accounting standards

Often less disclosure

Poor corporate governance (US investors don’t know how good they have it, or on the negative side, SOX chases foreign firms away from US listings.)

Inability to get fair redress in the courts

Language issues

Foreign trading costs if not listed in the US.

War

Exchange controls

As for me, I am mainly country-indifferent in investing. I agree with John Templeton, who said something to the effect of: “Buy the cheapest companies in a given industry.” I do look for the “rule of law,” though. Just as when we buy shares in a company, we check to see how they treat outside passive minority shareholders, with foreign firms, we have to go a step further, and ask how the country treats foreign outside passive minority shareholders.

With bonds the issue is simpler, because it boils down to yield, currency and repayment issues. The challenge there is to understand what will drive the relative forward interest rate policy between countries. In the intermediate term, it is better to invest in currencies where the central bank is tightening, particularly if there are any “surprise” tightenings.

I believe in international diversification; in general it is a good thing. But it should not be done blindly; investors should consider the factors that I have mentioned above, if not more factors.

Comments

[Tom B]

I totally 95% agree with your analysis. Having said that, I am heavily into diversified International stocks because of concerns about the dollar. With regards to accounting standards, I prefer countries with actual rules over BRIC and sub-BRIC countries-- I like the EU, Canada, Japan, Australia.

War concerns me, but I think N. Korea has cooled off a bit in recent weeks.