The Unique Risks of Investing Internationally
Foreign investing comes with some unique risks. None of the risks are deal killers, but they're still important for you to be aware of, including the following:
Currency risk: When you invest in foreign countries, you're taking on a hidden risk: exposure to rising and falling values of foreign money. When you invest in a company in a foreign country and the value of that country's currency rises, that makes your investment worth more.
Why? When you sell the investment or get dividends, you receive money in the foreign currency. But you can't buy food or pay the rent with the foreign currency. You need to turn those dividends and payments back into U.S. dollars.
To get dollars back, you must use the foreign currency to buy dollars. If that foreign currency rises in value compared to the dollar, you can buy more dollars, which boosts your return. Unfortunately, though, the opposite can happen, too. If the foreign currency declines in value, your returns take a hit when you buy dollars.
Oanda.com is a helpful online resource to find out more about currencies and exchange rates. Under the Currency Tools heading at the top of the screen, you can find online calculators that convert one currency into another and compare the values of hundreds of currencies. You can also download long-term exchange rate data if you scroll down to the Historical Exchange Rates link.
Political risk: An emerging nation might be a safe and stable place to invest until a new regime is voted into power. Practically overnight, a nation can go from being a welcoming place for outside investors to being both hostile and destabilized. You also bear the risk of civil unrest and war, which can greatly affect the value of your investment.
Regulatory risk: Some foreign countries don't have the same level of regulatory and financial oversight over companies doing business within their borders than the developed world does. Believe it or not, accounting rules might be more lax in some countries than they are in the United States, which might increase the chances of fraud.
Many foreign firms are required to file financial reports with the SEC. It's always a good idea to check to see whether a foreign company has filed regulatory reports before investing in it. Look closely to see whether the company has filed a form called the 20-F, which contains its full-year performance and is one of the more complete reports foreign companies file.
The SEC provides a full list of the forms some foreign companies must file. For more information on international securities regulation, the International Organization of Securities Commissions is a good resource.
Tax risk: The taxation of foreign investments is a complicated area. First, most foreign countries tax corporate profits and dividends paid to investors, just as the United States does. Those tax rates might be higher or lower than U.S. tax rates.
Furthermore, the tax due by foreign governments is usually taken or withheld from any money due to investors, such as a dividend. For instance, if an ADR pays you a $1-a-share dividend, you might receive only 90 cents after a 10-cent-a-share withholding is subtracted. The institution that creates the ADR might also charge a fee to pay the taxes to the foreign government.
The U.S. government might also tax your gains from international investments. And for many taxpayers, the U.S. tax rate charged on dividends received by foreign companies will be higher than the tax charged for dividends paid by U.S. stocks. Luckily, the Internal Revenue Service allows taxpayers to take a foreign tax credit to help defray these taxes.
If you're interested in how foreign investments are taxed — as well as how to claim the foreign tax credit on your tax form — check out the Internal Revenue Service's page.