What are the Risks of Foreign Stocks

Investors need to understand the additional risks they face from investing in foreign stocks. As mentioned earlier, all companies face business and financial risks, but additional risks pertain to foreign stocks. Currency fluctuations can adversely affect the value of stock for U.S. investors. If the value of a foreign currency moves sharply relative to the U.S. dollar, the value of the stock will either produce spectacular gains or very large losses, even if the stock price remains unchanged.

When buying foreign stocks, dollars are converted into the foreign currency of the stock. When the stock is sold, the proceeds in that currency are converted back into dollars. For example, the dollar has recently fallen against the Euro, which has provided rather large gains for U.S. investors in European stocks. However, if the dollar strengthens against the Euro, these gains could be reversed. Political risk is another important factor. The São Paulo stock market in Brazil plunged over 50 percent during the early part of 1994 when the socialist presidential candidate showed an initial lead in the polls. Thereafter, when the conservative candidate took the lead, the Brazilian stock market soared. The Mexican Bolsa also was badly shaken not only by the assassination of the leading presidential candidate before the elections but also by a peasant uprising. Many foreign countries tend to be less stable politically than the United States, and any political upheavals in these countries can erode foreign investments.

Another factor facing foreign investors is the information gap. Foreign companies whose shares are not traded on the U.S. stock exchanges do not have to follow U.S. accounting and reporting standards. Not being familiar with the accounting and financial standards of foreign companies can lead to inaccurate conclusions about a company. In countries where companies are not strictly regulated with regard to their adherence to accounting and financial standards, there is the additional risk of fraud. Many Russian investors lost their investments in the mutual fund called MMM when it turned out to be a pyramid scheme. For many foreign companies, information may be scarce, and even if there are reports in the financial newspapers, interested investors could miss them because they might not be feature news items.

Foreign companies whose stocks trade as American depository receipts (ADRs), explained in the next section of this chapter, on the U.S. exchanges are required to recast their financial statements using U.S. accounting standards. This can explain some of the differences in the reporting of accounting standards of foreign countries. When Daimler Benz, the German auto company, initially requested a listing on the U.S. stock exchange, it reported profits of $294 million in Germany. When their financial statements were converted into U.S. generally accepted accounting principles (GAAP), the profit was reduced by $60 million (Glasgall and Lindorff, 1994, p. 102). With less information available on foreign companies and different accounting procedures, investment decision making on foreign stocks becomes more complex than investing in American stocks. Quotes on some of the thinly traded foreign stocks (and the pink sheet ADRs that trade on the bulletin board) may be difficult to get, which can make it difficult to buy and sell at predetermined prices. However, this is changing as more of the computer online services go global and as more investors become interested in foreign stocks. Transaction costs of trading foreign stocks are much higher than American traded stocks. In addition, because of the lower volume of stocks traded, a large order by foreign standards, although reasonable by American standards, could cause a trading imbalance. This could result in larger price swings for the stock. This then poses the risk of liquidity. If there are no takers for a large sell order of stocks, then there could be increased bid and ask spreads in the bidding for these stocks.

These risks need to be weighed against the advantages of investing in foreign stocks. Despite the foreign-exchange risks over the long term, foreign stocks can balance a portfolio in terms of safety and can increase overall returns.

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