It has been almost a year since we announced that we had divested our portfolio of its remaining exposure to international stocks. We explained the reason why in our August 2020 post, Why We Sold All Our International Funds—that it doesn’t make sense to take the additional risks of investing in international stocks in return for what those risks can produce. Since we still get asked why we don’t own international stocks, I thought I would delve into those risks and how they should inform your investment decisions.
In framing this discussion, it’s essential to recognize that U.S. investors have a choice in where they invest their money. They can choose to invest only in the U.S., only in international stocks, or both. Many choose the latter because the conventional wisdom tells us that a sound portfolio strategy should include 10% to 20% of international exposure for purposes of diversification.
We don’t have any issue with that, especially if it’s done through an ETF or mutual fund that can diversify away some of the risks. However, when choosing stocks for our portfolio, we use a specific process to determine which stocks—U.S. or international—can generate the best risk-adjusted returns over time.
Our analysis tells us that, right now, the additional risks and uncertainty inherent in international markets make them inferior investments to U.S. stocks where there is much more transparency, and the political and currency risks are better known.
Here we explain what those additional risks and uncertainties are and why they need to be factored into your investing decisions.
Political risks are easiest to explain because they are often right out in the open. You can see conflicts, unrest, political upheaval, and changes in international policies as they occur. The problem is you can’t always see them coming. All of these factors can adversely impact companies’ operations.
You can avoid or minimize political risk by investing only in countries with stable governments, but that would leave out nearly two-thirds of the global economy. At least half the countries considered to be politically stable don’t offer any significant market opportunities. As far as those that do, you then have to consider other risks, such as lack of transparency and currency risk.
Lack of Transparency
There’s a reason why the U.S. attracts more investment capital than any country in the world. It’s because international investors and institutions trust us. More specifically, they trust our markets and our information. While our system is not perfect, its reliability and standards for information disclosure far exceed the rest of the world. U.S. companies are subject to near-complete transparency in disclosing their financials, allowing investors to make more informed decisions.
But that’s not how the rest of the world works. In most countries or markets, there is next to zero transparency. When you invest in international stocks, you are investing in companies that don’t have to play by the same rules as U.S. companies, even if they are listed on one of our exchanges. That has become a huge issue with China that does have companies listed on the NYSE and NASDAQ. Their presence on U.S. exchanges may give investors the impression that they must be operating by the same reporting rules as U.S. companies, but they’re not.
At least with U.S. companies, we know what rules they follow, which allows us to make an apples-to-apples comparison. Certainly, there may be some slight manipulation of GAAP rules, but there is enough data available to know what a company is all about. We say if you can’t know everything you need to know about a company, walk away.
Perhaps the least understood is currency risk. That’s because the value of a country’s currency is highly transient and can be influenced by countless factors. You can invest in a great company in a great industry that has made all the right decisions. But if the currency, for reasons entirely outside the company’s control, moves in the wrong direction, it can wipe out its gains. So, if the company achieves 10% growth and the country’s currency value decreased by 20%, you could be left with a 10% loss once the currency is translated back to the U.S. dollar.
A discussion of currency risk can get very convoluted, well beyond the comprehension of many investors. We can’t know at any given time all the factors that influence the value of a particular currency. The only thing we know for sure is it will be different ten minutes from now and a week from now because the world’s view of that currency is fickle, and the influencing factors are constantly changing. Suffice to say, as it relates to currency risk, we’re talking about forces that have the potential to completely overwhelm your investment results.
Why Assume the Risks if You Don’t Have to?
When making any investment decision, thoughtful investing requires that you understand the risks inherent in a company. With most international stocks, you are starting with at least the three risks discussed here, any of which has the potential to devastate your investment returns.
Here in the U.S, we have access to the most robust financial markets in the world with more than 3,000 publicly traded stocks with no (maybe some) political risk, no transparency risk, and no currency risk. All I would say is you want to play in another sandbox and invest internationally, you need to set a very high bar to compensate for all the attending risks. If you can’t get above that bar, then stick with what you know—U.S. stocks.