4 Reasons Investors Avoid Investing Internationally

Last Updated Sep 17, 2010 12:08 PM EDT

Like investors all over the globe, U.S. equity investors own portfolios that are almost exclusively domestic oriented, seemingly avoiding the diversification benefits provided by low correlating asset classes. The following are the four explanations I hear most often for the failure to diversify (or only diversify minimally) beyond domestic borders.

International Stocks Are Too Risky All equity investing is risky. However, U.S. investors are probably mistakenly overconfident about the relative prospects of the U.S. market relative to other markets. Behavioral finance studies have found that a common error among investors is to confuse the familiar with the safe. U.S. investors are more familiar with U.S. equities than foreign equities and thus assume they are safer. The same phenomenon can be seen throughout the world.

Even if the U.S. is the safest, that doesn't mean you should have all your eggs in one basket. You should never make the mistake of confusing even the highly likely as certain. As one example, Japanese investors in 1989 were probably thinking Japan was the safest place to invest.

U.S. Stocks Will Provide Higher Returns The very same investors who believe the U.S. is the safest place to invest also seem to believe that U.S. stocks will provide the highest returns. This is an illogical conclusion, unless you think the whole world is mispricing equities. Since risk and expected return must be related in a rational world, how can safe investments provide higher expected returns than risky ones?

U.S. Companies Are International Companies Many think you can gain all the international exposure that you need by investing in U.S. large-cap stocks, as they're mostly multinational companies with plenty of international exposure. The problem is that U.S. multinational stocks, while having exposure to foreign economies, trade mostly like U.S. stocks. They don't trade like foreign stocks.

The Dollar's Risk Is Too Great A common reason for avoiding international equity investing is that it entails another type of risk: currency risk. First, currency risk isn't a bad risk. It's a different type of risk than equity risk or small-cap or value risk (which have expected risk premiums as compensation). Currency risk has no expected return, hence no risk premium. However, adding currency risk provides a valuable diversification benefit against domestic fiscal and monetary policies. For example, domestic inflationary pressures are usually bad for domestic bonds and stocks and often lead to currency depreciation. Owning "currency risk" provides a hedge against such outcomes.

In effect, what most investors don't seem to understand is you're taking currency risk if you don't invest internationally. The risk is that the dollar will fall in value, deteriorating your cost of living. A falling dollar will not only lead to rising import costs, but also to rising prices from domestic competitors who are no longer faced with competing with cheap imports. This can also lead to rising inflation overall. This is what happened in the 1970s and early 1980s -- and it can happen again.

Owning international assets diversifies currency risk. Owning only U.S. stocks doesn't avoid currency risk. The risk is still there, only in a different form. If the dollar rises in value, it's likely that foreign equities will underperform (hence the currency risk). However, if the dollar falls in value, the cost of maintaining your lifestyle will rise. The difference is that in the first case (rising dollar) the risk shows up on your balance sheet. In the latter case (falling dollar) it doesn't. However, the risk is there nonetheless. The lack of visibility is one reason currency risk is misunderstood.

More on MoneyWatch:
International Diversification: Does It Still Work? The Investment World Is Not Flat A Deeper Look at the Investment Advising Industry What to Consider Before Investing in Corporate Bonds A Simple Way to Beat the Market
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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