Global diversification in a global economy.
First Vice President
From North Korea to Cyprus, Afghanistan to China, the policies and precedents of foreign lands impact our lives in ways we never believed possible. In fact, finding these places on a globe might have been a struggle for many of us a few years ago, but now they are places with which we are quite familiar.
More and more, we are reminded of how particularly small the world has become. As an investor, staying abreast of the activity in foreign markets is a prudent move. Holding investments which expose you to the unique risks and opportunities of the foreign markets can be an important part of a well-diversified portfolio. Here are some of these risks and opportunities:
Inter-currency exchange rates impact the real return from foreign investments. Simply put, if an American company earns a profit in euro and during that same period the U.S. dollar weakens relative to the euro, the profit is enhanced when converted to U.S. dollars. The opposite is also true, a stronger U.S. dollar dampens the returns earned abroad once converted. Whether you own investments denominated in U.S. dollars earning some profits abroad, or companies headquartered and earning in local currencies in foreign countries, there is some degree of currency risk and opportunity.
Cyprus has a smaller economy than Grand Rapids, Michigan, so why should we care what their economic policies are? The answer lies in the first sentence of this article, the world is small. It is not the size of the bank bailout that matters in Cyprus, but rather the way in which it was handled. The fact that Cypriot depositors, above a certain insured limit, had to share in the cost of the bailout directly and had that money basically 'taxed' right out of their accounts sets a frightening precedent for the rest of Europe, particularly for the smaller peripheral countries. This situation, along with the veiled threats from North Korea, and the ongoing instability in the Middle East, are examples of political risk. Nevertheless, opportunities do exist, as evidenced by positive changes in policy such as the legislation in Brazil designed to reduce their alarmingly high credit card interest rates.
As those who have foreign investments know, the domicile government of a foreign company often withholds taxes out of the dividends distributed by that company. An investor needs to be aware of the impact of such withholding taxes on the effective dividend yield of the foreign stock. Without getting into too much detail, the U.S. tax laws provide for a credit on foreign taxes paid that helps mitigate the impact of withholding taxes on foreign dividends. A tax professional should always be consulted with questions on this matter.
As foreign economies grow as a percentage of the world's GDP, it has become more important to allocate a portion of one's investment portfolio to non-U.S. asset classes. Many investors are underweighted in this area. See one of our Financial Advisors to help determine the most appropriate allocation for your portfolio and for guidance on how to best to achieve that allocation.
Please be aware of the specific risks associated with investing internationally, such as currency rate fluctuations and political changes. Yields are calculated in the currency in which the bond is denominated. Actual U.S. dollar returns can fluctuate positively or negatively with changes in the relative value of U.S. dollar. As with all bonds, investors bear the risk of the issuer satisfying the interest and principal payment obligations and the impact of future changes in tax related laws. This information may answer some questions, but is not intended to be a comprehensive analysis of the topic. In addition such information should not be relied upon as the only source of information, competent tax and legal advice should always be obtained.
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