Risks and rewards of global investing

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The world is getting smaller. American companies don’t dominate the global equity market as they did in the late 1960s. At the end of last, year non-U.S. equities accounted for 51 percent of the world’s stocks while American companies accounted for the remaining 49 percent, according to a paper released last week by mutual fund company Vanguard.

There’s a whole world out there

In today’s world, investing only in the U.S. means forgoing more than half of the global market. Besides opening up the universe of investments, there are other benefits to investing globally — namely diversification, according to the Vanguard report, “Global equities: Balancing home bias and diversification.”

International stocks tend to be uncorrelated with U.S. stocks. There are different pressures coming to bear on the stock prices of foreign companies than those of U.S.-based companies. As a result, their stock prices go up and down at different times. Though international stocks tend to be more volatile than U.S. stocks, adding them to a portfolio of American companies can actually lower the overall volatility of a portfolio.

Math stuff

Standard deviation is basically a measure of the volatility of an investment’s returns. Lower numbers indicate less volatility. In other words, potential returns probably won’t be incredibly far-flung from the average return. When you see a very large number, that means returns are all over the place.

For instance, according to a white paper by the asset management company Wealthfront, the annualized standard deviation for U.S. government bonds is 5 percent; for U.S. stocks it is 16 percent; for foreign stocks in developed countries, the standard deviation is 18 percent; and emerging market stocks clock in at 24 percent.

It’s all pretty math-intensive, but the standard deviation is part of why adding a more volatile asset to your portfolio could make your portfolio less volatile.

“Diversification is a function of each asset’s individual volatility as well as the correlation between those two assets or how they interact with each other over time. This means that you can combine two assets with different volatilities and depending on how they interact, you can actually end up with less total volatility than either of the assets individually,” says Christopher B. Philips, CFA, senior investment analyst in the Investment Strategy Group at Vanguard and author of the white paper on international investing.

In determining the correlation between two assets, analysts use the standard deviation as part of the formula. The impact of the addition of an asset class to your portfolio will depend on the respective weights of each asset as well. It’s a balancing act.

Sources of volatility

There are all kinds of risks that can throw stock markets into disarray. One of those is geopolitical risk, and there’s a prime example of that going on in Ukraine now. How do international investors guard against unexpected revolutions, interest rate madness and general unrest?

“If someone is a long-term investor, the best way to think about country risk is to simply diversify,” says Paul Christopher, CFA, chief international strategist with Wells Fargo Advisors.

“In general, country risk is very difficult to evaluate,” he says. “You can pay thousands of dollars to get country risk studies, but they don’t necessarily prepare you for what we saw in the Ukraine last week. And they don’t necessarily prepare you for a problem that has been festering for a long time suddenly taking the world stage, like we had in Argentina and Turkey in January.”

At the end of the day, the world really is shrinking. Investors can put money into businesses very nearly anywhere on the planet. The risks are different than those encountered at home, but a little bit of risk could actually help.

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Follow me on Twitter: @SheynaSteiner.

Senior investing reporter Sheyna Steiner is a co-author of “Future Millionaires’ Guidebook,” an e-book written by Bankrate editors and reporters. It’s available at all the major e-book retailers.