Why it pays to invest in foreign stocks

Many investors feel safer investing at home than in foreign stocks – but as the wobbly pound shows, that safety can be an illusion.

Man changing money at a Bureau de change © Alamy

It's not just holidaymakers who suffer when the pound is weak

The UK stockmarket accounts for less than 5% of shares listed around the world, yet the London-listed stocks still dominate most British investors' portfolios. The typical wealth manager keeps around half their clients' equity holdings in the UK, while smaller investors are likely to show an even greater home bias.

The standard argument for investing abroad is to broaden your opportunities. Why limit yourself to investing in the tiny universe of major British tech companies, for example, when you could buy Apple, Alphabet or Microsoft in the US? However, for many investors, that justification isn't especially compelling. The UK market has enough opportunities, as far as they are concerned, that the higher costs and additional complexity of dealing overseas doesn't seem worthwhile.

In reality, the idea that buying foreign shares is still a major hassle is misleading: most low-cost stockbrokers offer access to major US and European stocks at the very least. But it's still pretty understandable why many investors would rather stick to what they know. It's certainly possible to build a diversified portfolio of 20 high-quality companies that you're already familiar with just by investing in the UK market, so expending any extra effort to research international stocks may seem entirely unnecessary.

However, there's one type of risk that it's hard to avoid with a UK-focused portfolio those economic and political threats that are unique to the British economy. Recent wobbles in sterling are a small-scale demonstration of this: the pound is worth quite a few percent less against the euro or the dollar than it was earlier this year, as many holidaymakers will soon be noticing. And the wider trend in markets over the past three years shows clearly how an investor who only buys British is becoming poorer in global terms, often without realising it.

The MSCI UK index has returned around 10.5% per year (including dividends) over the past three years, which is worse than Europe (13%) and the US (17%) in sterling terms. And many of the larger UK companies that make up this index get most of their profits from overseas, which means that their shares tend to rise when sterling falls. The MSCI UK Mid Cap index, where overseas earnings are lower, has returned under 8% per year.

With no certainty about what will happen on Brexit day on 31 October, the simplest way to protect your wealth is to make sure that it's diversified around the world. That could mean investing directly in overseas shares, but favouring UK firms that do most of their business around the world or holding international funds is another simple option.

I wish I knew what diversification was, but I'm too embarrassed to ask

Diversification is the process of dividing your wealth between different investments to avoid being too reliant on any single one doing well. In plain English, it's all about making sure you don't keep all your eggs in one basket. The purpose of diversification is to reduce both your day-to-day risk (as measured by the volatility of your portfolio) and your potential for suffering uncommon but catastrophic losses, while maintaining a decent level of return.

For example, if you own just one stock, then your portfolio is entirely dependent on the fortunes of that one company. If you own 15, then even if one or two perform badly, or go bust, then the others in your portfolio should help to compensate for the loss.

While there's no ideal level of shares to hold, some research suggests that once you get above 20 well-selected shares, the marginal benefits of adding more is small. However, this assumes the shares are themselves well diversified if you hold just 20 oil companies, for example, you are still heavily exposed to the risks of a single sector. In addition, the size of each investment is important: if you have 100 shares, but half your portfolio in a single stock, you are not sensibly diversified. A good diversification strategy combines all these principles: you might set yourself a rule of holding 20 stocks, with no more than two in each sector and no more than 10% of your portfolio in a single stock (and no more than 20% in three and so on).

As well as diversification within an asset class, you should diversify between asset classes, because different assets tend to behave in different ways depending on the economic backdrop. For example, bonds will do well during periods of falling or low inflation, while gold tends to benefit during periods of financial instability. Your exact mix of assets or asset allocation will depend on your investment time horizon and risk appetite.

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