Investing globally has never been easier. With the click of a mouse, an investor can access research and data on public companies from London to Bangkok, and with another, buy shares through a mutual fund, depository receipt, or directly through an international exchange. This level of information and access is unprecedented.
Paradoxically though, the same factors that make investing abroad easier may challenge the logic of doing so. As markets and people become more interconnected, they appear to be increasingly impacted by one another. A financial crisis or bear market in one country seems to spread like falling dominoes, causing markets to plunge throughout the world.
What does this mean for investors? Conventional wisdom holds that exposure to foreign equities can not only enhance returns, but lower portfolio risk too. If returns in every market around the world become more correlated, that paradigm is weakened. Since this topic has taken on fresh relevance as new studies improve upon old research and the world reels from the U.S.’s tech-bubble collapse, it may be helpful to review the current debate over international investing.
The Global Investing Paradigm
Fifty years ago, Harry Markowitz, then a 25 year old economist, published a paper that profoundly changed the nature of financial management. Prior research focused on the risk- reward trade-off of individual securities, but failed to recognize the interrelationship of those securities as part of a portfolio. The new body of thought considered the impact that securities of varying characteristics had on the volatility and return of a portfolio, and concluded that diversification was the only prudent choice for investing under uncertainty.
The new paradigm, for which his contribution earned Dr. Markowitz a Nobel Prize, was finally embodied in U.S. law by the 1974 Employee Retirement Income Security Act (ERISA). That law helped usher in the era of “modern portfolio theory” and the concept of asset allocation. Modern portfolio theory defines an “optimal” portfolio as consisting of a group of assets that achieve the highest possible (expected) return for a given level of risk. To achieve that optimality, assets are chosen, in part, by considering their relationship to one another, so that when one is performing poorly, others are at least not systematically affected. Logically, investors will seek out all possibilities for diversification that meet their risk parameters. Research in the late 1960s illustrated that the same diversification benefits could be derived using foreign investments as part of the mix. In short, any market that doesn’t move regularly upon the vicissitudes of an investor’s home market is an opportunity for diversification.
Foreign investing grew steadily through the decades. According to the United States Treasury Department, U.S. portfolio investment in foreign securities grew from $89 billion in 1984, when they began calculating the data, to roughly $1.8 trillion by 1997. At the same time, free-trade and capitalism became the mantra for politicians around the world, financial infrastructures were deregulated, and the technology revolution helped to ease the flow of information and capital.
Also in This Issue:
Is That A $100 Bill Lying On The Ground? Two Views Of Market Efficiency
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked By Yield
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