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An article from Motley Fool recently hit my inbox about investing 15% to 30% of your money in foreign stocks.
The reasons they cited for doing so were diversification, exposure to big-name brands outside of the United States (that aren't listed on major U.S. stock exchanges), and exposure to economies growing faster than the U.S.
Now I've heard this all before – and I'm sure you have, too.
But there's one reason they're wrong.
And it's a big one…
Foreign Stocks Aren't as Liquid as You May Think
Diversification is a very nice, impressive-sounding word used to describe owning a variety of different investments in your portfolio (i.e., all of the money you've put into that account).
The premise behind having a diversified portfolio is to provide protection for your portfolio in the event that one sector or class of funds suffers greater losses than the others.
If you have your money invested in just one sector or class of funds, such as housing stocks, and there is a significant downturn in that industry, then you take a hit on all of that money you invested. And that loss could end up being too great to recover. And if you're a commodities investor and only keep things like gold and silver in your portfolio, you face the same risk – losing 100% of your capital and your profits.
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Now the most common piece of advice that's offered to prevent this sort of doomsday scenario is to expand your portfolio holdings beyond the United States. Many advisors, money managers, and financial authors will tell you not to keep all of your money just in U.S. stocks in the event they fall out of favor. Instead, they'll tell you to put 15% to 30% of your money in foreign stocks or exchange-traded funds (ETFs).
Investing in foreign stocks can provide diversification and also provide you with a chance of having ownership in a company whose stock can show a rapid rise in price; those stocks that are in what's called an emerging market.
But here's why I'm not a fan of doing that – and why you shouldn't be, either…
Aside from those two possible advantages, there's one major risk that'd make me choose domestic diversification over our foreign counterparts any day of the week.
And it's called… liquidity.
Liquidity is the ease with which a market can be traded. Liquidity is what allows you to get your trades filled easily – and it's what allows you to get out of them quickly. More open contracts means higher liquidity, while less open contracts means lower liquidity. Higher liquidity makes it easier for you get your orders filled and quicker for you to exit your trades. Lower liquidity makes it harder for you to get your orders filled and slower for you to exit your trades.
And from an investment perspective, the liquidity in foreign stocks just isn't comparable to the liquidity in so many other U.S. stocks that are available to you right now. And with respect to emerging markets, those companies just don't have the market efficiencies, accounting, and securities regulations of those in the United States.
Foreign stocks aren't always the easiest to evaluate, either – especially within the emerging markets sector. Those stocks tend to be more volatile due to political and economic events. And if you have any problem with your investment, it's pretty unlikely that you will be able to get a U.S. judgment against a non-U.S. company. And keep in mind that currency exchange rates can affect your gains – positively and negatively.
So while I'm a huge fan of diversification… there are far better ways than throwing your money into foreign stocks and ETFs to do it.
Your Alternatives to Investing in Foreign Stocks
As you probably know by now, I love options. And as a trader, I look for options with the highest possible liquidity.
Now if a foreign stock doesn't have the same liquidity as a U.S. stock, trying to trade the options on these securities will be the utmost challenge. And of course, you'll need a broker that will allow you to trade options on foreign stocks. Even having wide bid and ask spreads in the options puts you at risk for only making back what you paid to get in the trade.
And who wants to have to work that hard just to break even on an options trade?
So instead of buying foreign stocks or buying options on foreign stocks, here are two alternatives to consider:
- Trading American depository receipts (ADRs)
- Trading foreign ordinary stocks over-the-counter (OTC)
ADRs are stocks that trade on the U.S. exchanges but represent a certain number of shares in a foreign corporation.
You can invest in stocks that are classified as a foreign ordinary, which means they can be bought and sold on the U.S. OTC market or as a foreign ordinary (local market). On orders of over $5,000, buying from the local exchange may be the best cost-option trade than buying and selling in the OTC market.
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About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.