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Investing Classroom: Diversify with Foreign Stocks

Portfolio lesson 5.5: What role can international equities play in your portfolio?

Morningstar 25 March, 2010 | 5:46PM

They're the Holy Trinity of your equity portfolio. Own a blend of large and small UK companies' stocks and a dose of foreign issues, and you'll improve the risk/return profile of your stock portfolio, say the academics and the financial pros. As a result, investors diligently sink pounds into international stocks and funds.

But what role can foreign stocks play in your portfolio?

Supporting the Diversification Theory
Investors may get more diversification from their foreign investments by steering clear of multinationals and large-company world funds, which may be more strongly correlated with domestic holdings, and focusing instead on more-esoteric--and riskier--choices. If you choose to gain exposure to these types of stocks, consider doing it through a fund that specialises in one of these areas. It's a less risky proposition.

Emerging markets: These funds have always provided good diversification, and they are becoming even better diversifiers as the industry progresses. Not so long ago, emerging-markets managers did most of their hunting in Latin America and the Pacific Rim. Because many of the so-called Asian Tiger funds--most notably Hong Kong and Malaysia offerings--peg the value of their currencies to the pound, currency fluctuations played only a small role in total returns.

Today, however, emerging-markets funds buy once-exotic fare such as Polish, Russian, or Turkish securities. In fact, Russian equity funds were among the top performers over the past year.

Latin America: Intrepid investors could ditch diversified emerging-markets funds altogether and focus on Latin America. Although Latin America's most prominent markets, Brazil and Mexico, have strong economic ties to the United States, their currencies and markets have most often followed internal cues.

International small-caps: Think small, as in Europe's small companies. Early evidence from a new breed of foreign-stock funds focusing on smaller companies suggests that stocks of smaller foreign companies may provide effective diversification.

Intuitively, it's easy to see why this would be true. Just like domestic small caps, foreign small companies do most of their business at home rather than abroad. As a result, they're more sensitive to changes in their local economies than the large companies that make up the major indices are.

How to Use Foreign Stocks in Your Portfolio
If and how you use foreign stocks in your portfolio is up to you. We suggest that you think about foreign stocks in one of two ways:

1. If you want to own foreign stocks for opportunity, not diversification, consider simply dividing your portfolio into large companies and small companies, and within those two categories, include both UK and foreign stocks. So for purposes of portfolio building, Kraft wouldn't qualify as a foreign stock, but as a large-company stock.

1. If you want to own foreign stocks for diversification, consider choosing from less-travelled areas, such as emerging markets or smaller-company stocks.

Overseas investing can be trying--the territory is vast, the issues many, and the rules seem to be shifting--but that doesn't mean you shouldn't give it a go. There are plenty of opportunities out there and many emerging markets funds have received our highest Qualitative Ratings--check out our Fund QuickRank to find out which ones.

For more investing lessons on equities, bonds, funds and portfolio management, check out our Learning Centre.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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