While the United States equity market is a juggernaut comprising almost 55% of all global equity, it is not the only kid on the block. The rest of the world participates in the purchase and sale of securities, many of which are available to the American investor. What are the pros and cons of investing in foreign securities?

The first reason for overseas investment is that it allows the investor to participate in the other 45% of global equity (or at least the portion of which is available to Americans). These investments may provide the opportunity for dramatic growth, especially in emerging markets. Perhaps the most compelling reason to invest internationally, however, is that the returns of many overseas markets are not well correlated or not correlated at all with domestic market returns. Thus, foreign investment offers the investor a very sensible avenue for diversification.

International investments suffer from some systemic, non-diversifiable risks that are absent in domestic markets. Though unlikely, political forces may cause investment losses, such as when Cuba nationalized the facilities of US firms. Dividends and interest received on overseas investments may be subject to foreign taxation (though this risk is mitigated to some extent by the availability of foreign tax credits for investors). Currency fluctuations may also cause the value of your investment to change, even in the absence of a change in the underlying security price.

Finally, there are often greater costs associated with entering foreign markets. These costs can be prohibitive for individual investors and have a significant effect even on low-cost index funds. For example, the current expense ratio on the Vanguard Total Stock Market Index Fund (VTSMX, one of the broadest domestic index funds) is 0.19%. The Vanguard Total International Stock Market Index Fund (VGSTX) has a significantly higher expense ratio at 0.32%. While that difference may seem insignificant, consider $100,000 invested in either fund for thirty years. If both funds returned 12%, the higher expense ratio would reduce the value of your investment by $108,511 compared to the lower cost fund.

All of these risks contribute to the potential for greater volatility in overseas investments. Despite this, international securities are very deserving of a place in any long-term investor’s portfolio. I believe that, in the case of young investors building a retirement nest egg, up 40% international allocation split between foreign developed and emerging markets is not unreasonable. I will detail changes to my preferred retirement portfolio for young folks in an upcoming post.