Academic journal article New England Economic Review

Should U.S. Investors Invest Overseas?

Academic journal article New England Economic Review

Should U.S. Investors Invest Overseas?

Article excerpt

Interest in foreign investment has been high among U.S. investors in recent years. The unprecedented growth of 401k pension plans has greatly increased the number of people who must make their own investment decisions in planning for their retirement. Many investors know that geographic diversification can improve investment returns without increasing risk. However, whether or not to invest abroad and, if so, how much weight to give to foreign investment, are questions often subject to heated debate. Some investment advisors recommend that U.S. investors put as much as one-third of their stock portfolio in foreign stocks to take advantage of the benefits of diversification. Others believe that foreign investment should play only a small role, if any, in a U.S. investor's stock portfolio. They argue that political uncertainties and currency fluctuations make the value of foreign investments far more volatile for the investor without the offsetting benefits of higher returns, and that diversification benefits are not enough to offset this disadvantage. [1] Moreover, U.S. investors can get overseas exposure by investing in the stocks of domestic companies. Many U.S. multinationals that are part of the Dow Jones Industrial Average, such as IBM and Coca-Cola, derive a substantial portion of their revenue from overseas operations.

The question of whether or not to invest abroad is part of the larger question of how to assemble a portfolio that is appropriate for the investor's circumstances and degree of risk tolerance. Modern portfolio theory, introduced by Markowitz in the 1950s, uses optimization techniques and historical data on the returns, risks, and correlations of available securities to construct a portfolio with the lowest possible risk for a given level of return. The theory has been widely accepted for almost half a century, and it has found practical applications among pension funds and other institutional investors in the past 20 years. Because of heavy data demands and computational intensity, however, it has largely been out of reach of individual investors. With the advent of cheap computing power and the Internet, commercial services are beginning to bring portfolio optimization to individual investors participating in 401k plans.

This article examines the question of international investing within the broader context of the use of portfolio optimization by individual investors. It illustrates the concept by constructing portfolios from index funds based on major asset classes, including two foreign indices, European and Pacific, in addition to domestic stocks, bonds, and Treasury bills. Different measures of historical returns on these assets are used to construct optimal portfolios for various levels of risk. We find that the results of portfolio optimization are highly sensitive to input parameters and, thus, to the way historical returns are measured.

I. Ways to Invest Overseas

In investing overseas, U.S. investors have a number of options, depending on the level of detail and control they want to have over their investment. Some investors buy foreign stocks directly on foreign stock exchanges. However, investors face a number of obstacles in doing this, including lack of information, unfamiliar market practices and tax rules, undependable settlements, and costly currency conversions. High transaction costs associated with direct purchases of securities overseas make this option impractical for many small investors.

One alternative to direct investment is American Depositary Receipts (ADRs), also known as Global Depositary Receipts (GDRs). An ADR is a negotiable certificate that represents a foreign company's publicly traded equity or debt. An ADR is created when a broker purchases the actual shares in the foreign market and deposits them with a local custodian bank. The U.S. depositary bank then issues ADRs representing these shares. ADRs trade freely in the United States, just like any other security, either on an exchange or in the over-the-counter market. …

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