In the new economy, investors looking for ways to diversify their portfolios have a world of opportunity.
To diversify a portfolio that’s concentrated in US securities, you may want to add the equity and debt of companies that are registered in other countries. Global investing can be an effective way to help offset investment risk, in large part because while world markets are interconnected, they’re not always positively correlated.
In fact, the cyclical ups and downs in a country’s or region’s securities markets tend to be more sensitive to the local environment, including interest rates and employment levels, than to what’s happening globally — though there are exceptions.
International investing risks
Investing globally means taking on many of the same risks you face when you invest at home. Prices may fall rather than rise. Dividends may be cut. Interest earnings may decline. But it may also mean taking on some risks that you hadn’t anticipated.
- Some markets may be less liquid than others, so it may be hard to buy or sell at the price you want.
- Some less regulated markets may provide fewer investor protections.
- It may be harder to find reliable information about the potential risks an investment poses.
- Political and economic instability in a country or region can affect investment values.
- Changes in currency values can have major consequences.
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Investment return in an overseas market, as in a domestic one, depends on growth in the value of the investments you make, your dividend or interest income, or a combination of growth and income. But there’s another factor in play when you invest away from home: floating currency values. A significant gain or loss in the value of the dollar in relation to the value of the currency in which an investment is priced can have a major impact on your profit or loss if you sell.
Unlike a volatile stock, whose price can change quickly, shifts in currency rates tend to occur gradually. While you can’t predict when your financial interests will align with what’s happening in the stock market, in most cases you should have time to buy or sell while currency values are still working to your advantage.
The currency risk — and its reward
Whether you invest directly or indirectly in securities priced in currencies other than the US dollar, it helps to understand how changing currency values affect the cost of investments you make.
Generally speaking, buying securities when the dollar is strong means investing costs you less. The same is true when you pay for any other product, such as a sweater or a train ticket, denominated in a currency that is weaker than the dollar.
Conversely, selling a stock when the dollar is strong reduces your return. That’s because the weaker currency in which you invest translates into fewer dollars.
To convert the price per share from one currency to another, you calculate the exchange rate by dividing one currency by the other. If you are using US dollars to buy stocks priced in euros, you divide euros by dollars.
In the example shown in the chart, if the euro is 1:10 to the dollar, the exchange rate is 1.1 (€1.10 ÷ $1 = 1.1). If the euro is 0.90 to the dollar, the exchange rate is 0.9 (€0.90 ÷ $1 = 0.9).
To find the price (C) in the currency you’re using, you multiply the security’s price (A) times the exchange rate (B).
A x B = C €50 x 1.1 = $55
Gain or loss
If you buy a stock priced in euros when the euro and the dollar are at par, the amount you pay is the same. In the example here, it’s $50 or €50 a share.
If the value of the euro is stronger than the value of the dollar, it costs you more per share to buy than it would cost an investor using euros. When the euro is 1.10 to the dollar, a €50 stock would cost a US investor $55. If the euro gains value, the per-share cost in dollars increases.
But if the dollar is stronger than the euro, the cost per share for an investor using dollars is less than the price in euros. When the euro is 0.90 to the dollar, a €50 stock would cost a US investor $45. If the dollar gains more, the cost per share drops still further.
If the underlying stock increases or decreases in value, the gain or loss for an investor using dollars will reflect, but not necessarily be identical to, the gain or loss for an investor using euros. The greatest gain in dollars occurs if the share price increases and the dollar loses value.
*These hypothetical examples, which don’t include the impact of commissions or taxes, do not reflect the performance of any specific investments.
International Investing For Beginners by Inna Rosputnia
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