Last Updated on October 25, 2022
“Do I need international stocks?” is a common question that is heard after strong returns in US markets.
People start asking, “Can I just invest in the S&P 500?” or “Should I only own US stocks?”
Depending on the time period and who you are talking to, you will hear very different responses.
Some people claim you only need to invest in US stocks. Others say owning international stocks is prudent.
What’s the right answer? Do you need international stocks?
The answer is…*drumroll please*…it depends.
Let’s look at what international stocks are, advantages of international stocks, risk of investing in international stocks, how much you should invest, and how to invest in international stocks.
What are International Stocks?
International stocks are shares of companies outside of the United States.
There are three main categories:
- Developed International
- Emerging Markets
- Frontier Markets
Developed international stocks are companies located in countries with more mature economies, higher standards of living, political stability (at least historically!), stronger property rights, and more stable currencies.
They normally have strong regulatory institutions and are more accessible to foreign investors.
Some index providers categorize certain countries as developed international while others categorize them as emerging. It depends on their methodology.
For example, FTSE started classifying South Korea as a developed market in 2009 whereas MSCI still classifies it as an emerging market.
Below are a few developed international country examples as of this writing:
- United Kingdom
- Hong Kong
Developed markets are mostly western Europe, Japan, Canada, Australia, and a few other countries.
Emerging market stocks are companies located in countries with less mature economies, lower standards of living, more political instability, less secure property rights, and more unstable currencies.
They normally have developing regulatory institutions and are less accessible to foreign investors.
An emerging market country may be transitioning into a developed international market, where it can participate in more of the global economy.
Below are a few emerging market country examples as of this writing:
- South Korea
Frontier market stocks are companies located in countries that are less developed than emerging market economies. You can think of them as pre-emerging market economies.
Below are a few emerging market country examples as of this writing:
Advantages of Investing in International Stocks
Although you may read articles about how international stocks have been a drag on returns for the past decade (and they are correct), there are advantages to investing in international stocks.
One advantage of investing in international stocks is that it provides diversification.
Many investors have a “home-country bias”, where they invest more in their home country than other markets. This phenomenon isn’t unique to the US. Investors from other countries do it, too.
Similar to not putting all of your eggs in one basket with an individual stock, you may also not want to put all of your eggs in one geographic basket. There is a diversification benefit to owning international stocks because sometimes they will perform better than US stocks during different time periods. They may lower the risk of your portfolio.
If your US stocks are performing poorly, it can help when your international stocks are performing well.
People sometimes claim that you can get international exposure simply by owning US companies with overseas operations. Although that provides exposure to overseas revenue, the companies are likely going to be more correlated with US stocks than international stocks, meaning that they will go up and down as US markets go up and down – not with international markets.
This is problematic because if you want an investment that “zags” while another “zigs” (the point of diversification), a US company with overseas revenue or exposure isn’t going to help much.
Below is a chart of two different decades, 2000 to 2009 and 2010 to 2019.
As you can see, the US market did well in the most recent decade, but actually had negative performance the prior decade.
Although in the short-term, US and international markets can move similarly, over multiple years, and even decades, international markets can have stronger performance than US markets and vice versa.
Many people look at the most recent time period and assume US stocks are superior and will continue to do better, but there is no clear evidence that is the case. Many people fall victim to recency bias and put too much emphasis on what has happened recently, instead of looking at past periods and experiences outside of their own.
Participate in Global Growth
Another benefit of owning international stocks is that you are participating in the cleverness, intelligence, ideas, work ethic, and minds of people across the world.
The US makes up about 60% of the world stock market based on market capitalization. If you own more than 60% US stocks in your portfolio, you are underweighting international stocks and choosing to participate less with what the rest of the world has to offer.
I don’t believe the US has a monopoly on the best minds, profitable businesses, or strong work ethic. Personally, I want to be able to participate in the profits that people create across the world.
Plus, other countries are growing rapidly. They may have more room to expand, and the companies within those countries have the potential to deliver solid returns.
It’s similar to how a small business has more opportunity to grow into a larger business than a large business has to grow into an even larger business.
International stocks can give you exposure to global growth and potentially higher returns in faster growing economies.
Disadvantages and Risks of Investing in International Stocks
While there are advantages, there are disadvantages and risks of investing in international stocks.
When you own international stocks, you often are exposed to currency risk because shares of international stocks usually trade in their own currencies – not US dollars.
If the US dollar increases in value relative to another currency, that will impact your overall return. For example, international stocks could rise in value, but if the US dollar appreciates against the other currency, your return could be negative.
You could even have a negative return in international stocks, but if the US dollar goes down relative to the other currency, your return could be positive.
In other words, when you invest in international stocks, you take on the price risk of the stocks and the currency risk.
Although there are funds that hedge currency fluctuations, over time, currency fluctuations tend to wash out, but in the short-term, currency movements can have a dramatic impact on returns. The expected return of currencies is 0%, which is why if you are a long-term investor, there are very few reasons to hedge the currency risk when investing in stocks.
Currency risk and the visible impact is easier to see in international bonds because returns tend to be lower in bonds, so movement in a currency can easily add or subtract to the return. In stocks, it’s often less easy to see, though during times when the dollar is appreciating significantly, you may wonder why your international stocks are returning less than you thought. It could be attributed to the currency movement.
There is the geopolitical risk of wars, tensions between countries, and cyberattacks. Check out this dashboard by BlackRock, which tracks different risks and the attention they have been receiving.
I don’t put any indicative power to these risk indicators, but it gives you a good idea of what types of risks there have been in the recent past.
Many international funds owned Russian companies and when Russia invaded Ukraine, Russian stocks stopped trading for a time period and benchmark providers removed them from their indices.
Many international stocks have less information about them or have different reporting requirements than a US-based company. For example, think about all the publicly available information you can find on a company in the S&P 500. They have disclosure requirements and many analysts follow the stock.
There may be less stringent reporting requirements for international stocks, and fewer analysts may follow them.
If you own a broadly diversified fund instead of individual stocks, this is likely less of an issue.
International stocks may have less liquidity, or trade less frequently.
For example, large companies in the S&P 500 may trade hands millions of times a day. For certain international stocks, they may only trade thousands or hundreds of times per day. If it’s a small enough company, it may not even trade on a daily basis.
Many people don’t think about liquidity until they need it or there is little to none.
For people with a globally diversified portfolio who have cash on hand, less liquidity is likely not a big issue.
Foreign Tax Credit
If you own international stocks inside of a brokerage account, you may receive a foreign tax credit on your 1099-DIV in box 7. When international stocks pay a dividend, the tax due on it may be withheld, which is different from the US where nothing is withheld and it’s trued up on your tax return.
You may receive a credit to avoid having the dividend taxed twice – once by the other government and once by the United States.
It’s one more tax reporting piece of information you’ll want to include when preparing your tax return.
If the international stocks are held in your IRA, you don’t get a foreign tax credit and don’t need to worry about extra reporting on your tax return, but the tax paid to the foreign government is lost forever; however, don’t worry – it’s not usually a significant amount.
The foreign tax credit is a very minor consideration, but it’s worth mentioning because it is one more disadvantage of investing in international stocks.
How Much Should Be Invested in International Stocks?
Many websites recommend investing 20% to 50% of your portfolio in international stocks while your friends may say they don’t own any.
What’s the right amount in international stocks?
As mentioned earlier, it depends.
Some people are fine owning 100% US stocks and facing the possibility that returns are negative for 10 plus years.
Some people want some exposure, but don’t want it as high as the global market capitalization (roughly 60% US stocks and 40% international stocks).
Others want it near the global market capitalization while others overweight international stocks.
There is no right answer, but you should be aware that if you own less than 40% as of this writing, you may have a home country bias, less diversification, and miss out on the talent of people in other countries.
The key is to know the data, pick an amount, and include it in your investment policy statement.
How to Invest in International Stocks
There are different ways to gain access to international stocks.
If you want to purchase stocks directly on foreign exchanges, you could open an account that allows for international trading.
For most people, this isn’t going to be an easy or efficient way of trading international stocks.
American Depository Receipts (ADRs)
You could buy ADRs, which are certificates issued by US-based banks that represent shares in an international company.
The ratio of one ADR to shares will vary by company. For example, one ADR could be one share, or it could be five shares. ADRs are generally denominated in US dollars.
ADRs are a way for international companies to trade on US stock exchanges.
ADRs are a reasonable way to gain access to international stocks without needing to trade directly on foreign stock exchanges.
ETFs or Mutual Funds
The easiest way to gain exposure to international stocks is to buy an ETF or mutual fund that tracks international stocks.
There are many ETFs or mutual funds with low expense ratios that are tax-efficient that can give you access to a diversified basket of international stocks. Although there are funds that track specific countries or regions, the more specific the fund, the less diversified you will be.
ETFs tracking an international index make it convenient and easy to buy or sell international stocks in a normal brokerage or retirement account.
Final Thoughts – My Question for You
International stocks have fallen out of favor over the last decade, but the decade before it was a different story, when international stocks had far better performance than US stocks.
Owning international stocks is a way to participate in the companies of developed international, emerging, and frontier markets. It’s a way to stay diversified and participate in global growth.
Although there are many advantages to owning international stocks, currency risk and geopolitical risk are two disadvantages.
How much you invest in international stocks is ultimately up to you. You need to decide what you are comfortable with given your circumstances and the historical data.
Although you can access international stocks a variety of ways, ETFs and mutual funds are attractive given their low costs and convenience.
I’ll leave you with one question to act on.
What percentage of international stocks do you have, and do you want to make any changes?