My pick of the week’s money and investing articles.

A barely reported bit of news yesterday from the Fitch ratings agency should make pleasant reading in the parts of Europe that animal spirits can’t currently reach:

Fitch says Iceland’s long-term debt is now safe to buy, adding the outlook for the tiny North Altantic nation is stable.

Fitch upgraded Iceland’s debt to BBB- from BB+, lifting it out of junk status. Fitch cited the slow but steady progress made by Iceland in emerging from its 2008 banking and currency crisis.

Iceland’s debt-laden economy was the first to crumple under the weight of the credit crunch, but has since begun to recover.

I’m not going to rehash the arguments over how Iceland got into its predicament again, nor wax lyrical about the similarities and differences with Italy or Spain, or Greece for that matter.

The short answer is Iceland has control of its own currency, a small population, rich resources, and a tradition of turning to government – and its own people – to reinvent itself out of a hole.

Other countries have different advantages, and problems, too. The important point is that doom-laden headlines such as those written about Iceland at the height of its banking crisis ought to be taken with a pinch of salt – and perhaps even treated as a cue to buy.

Particularly if they’re written by hysterical bloggers or the lunatic fringe of financial bulletin boards.

Most of the commentary about Italy, for example, has been truly dire. As I’ve written before, Italy is one of the richest countries in the world. It has pressing structural issues, sure, but it is only bankrupt in the sense that a man with a £1 million mortgage on 10 buy-to-let properties worth £5 million is bankrupt.

Which is to say – it isn’t.

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Sensible investors put their money to work across the world, rather than only investing it at home.

Buy British or Made in USA are good slogans for the sellers of knitwear, tractors, and cauliflowers, but they’re a poor guide if you want to build a robust portfolio.

This isn’t because I expect the British stock market to whither away like our coal mining or ship building industries did, or because the troubled UK economy is doomed.

On the contrary, I think the London Stock Exchange is one of the world’s most attractive, with companies that offer an appealing mix of growth, income, stability, and innovation.

As for the UK economy, reports of its death are much exaggerated.

Besides, the biggest UK companies that dominate the FTSE All-Share index do over 75% of their business overseas. This means they’re far less dependent on the performance of Blighty PLC than is popularly supposed.

But our companies are more exposed to certain regions of the world than others.

It’s been said, for example, that we export more to Ireland than we do to the BRIC1 nations combined, which is a tad worrying given how it sometimes seems there are more Irish backpackers in Irish bars across the world than there are Irish citizens in Ireland!

More generally, UK trade is dominated by business done with mainland Europe.

But trade is a global affair nowadays.

Investing overseas therefore gives you access to different types of companies and opportunities, unconstrained by history or the geographic accident of our lump of rock’s position on the spinning globe.

Gambling with your country’s money

Investing in foreign shares exposes you to currency risk, which is to say your overseas investments will change in value as their price in the local currency fluctuates when converted back into pound sterling.

In the short-term this can be a good or bad thing, in terms of your profit – it depends how exchange rates go after you make your overseas investment.

Over the long-term, however, currency variations on average play a minor role in total equity returns. Currency hedging is expensive and difficult for private investors, so I wouldn’t worry too much about it provided you’ve got a long time horizon and you’re spreading your equity buying across the world.

Oh, and in case you’re wondering if overseas investing means you’ll need to phone city boys in Shanghai or Sydney to place trades, fear not!

While you can hold even individual foreign company shares in an ISA, the majority of us are best off using collective funds for the money we invest away from our home country.

(Most of us are best off in UK trackers, too, for that matter, but that’s a different dozen or so articles).

Investing overseas via funds could entail you buying index trackers that follow foreign markets, like those we use in our Slow & Steady model portfolio. You can even track emerging markets using passive funds.

Alternatively, new country-specific ETFs are debuting all the time, though most investors will find it simpler and safer to aim for broader regional exposure.

Some investors like myself also put money into big global investment trusts like RIT Capital Partners. This trust invests very widely around the world, and its managers actively monitor currency exposure as an added benefit (or not, as it may turn out) for its shareholders.

Investing globally is more helpful with shares than bonds

The main benefit of investing overseas is that diversification across countries can be expected to reduce risk in your portfolio, without doing too much damage to your overall return.

According to the latest research from the very credible London Business School2, the risk reduction you’d have seen from holding the world index rather than owning only domestic equities between 1972 and 2011 made diversification worthwhile for every major country studied except South Africa.

They found that investors in the core 19 countries looked at3 would have enjoyed a risk reduction of on average 20% from holding the world index, as opposed to if they’d held only their own countries’ shares.

Academically speaking, that’s a trade-off you should take, even if it slightly reduces your return (though see below for more comments on risk).

Investors from Norway and Finland would have seen around a 50% reduction in risk, due to how skewed their economies are, and the overweight presence of a few massively larger companies. Take note, if you’re Norwegian or Finnish!

Interestingly, the professors do not report the same risk-reducing benefits from diversifying into global bonds.

With bonds, the currency risk outweighs the benefits of diversification.

This is probably because in general, a creditworthy government bond is a creditworthy government bond – it pays you a fixed rate of interest and you (hopefully) get your money back when the bond matures.

Hence currency risk looms large with bonds, compared to the minor diversification benefits of holding one developed country’s bond versus another, given that most mature developed world sovereigns have not defaulted in the past few decades. (Some might suggest the professors stand ready to re-write their rule books.)

In contrast to bonds, by buying foreign shares, you are getting access to different country’s industries, trading partners, local specialisms and resources, as well as varied politics and demographics.

That’s real diversification!

The risks of picking the best countries to invest in

Some foreign share markets will likely do a lot better than others in our lifetime, of course.

This means spreading money across the world’s stock markets will likely reduce your returns, compared to if you bought only the best performing markets.

But before you put on your red braces and go winner-spotting, keep in mind:

• Picking winners on the basis of, say, historically faster-growing GDP is a losing strategy.

• Investing in fewer overseas markets will lower the risk-reducing benefits you’ll enjoy, compared to investing in the global index.

• Most people are likely to be as bad at picking winning markets as they are at picking winning stocks, so they will lose to a global tracker (or else they’ll simply pay for any higher returns by taking more risk – see below).

• If a market grows faster or looks cheaper, it may be for a good reason (likely because it will be more risky and/or volatile).

• You’re more likely to stomach the most volatile but potentially highest reward markets – e.g. Brazil or Russia – if their gyrations are offset by steadier holdings elsewhere in your portfolio.

Remember, risk isn’t necessarily something to be entirely shunned. I haven’t got a problem with a young investor putting a bigger allocation into a spread of emerging markets, say, for the prospect of higher long-term returns, provided they’ve understood the extra volatility that’s likely along the way.

But I would still argue against betting very heavily on any particular country, or even region, in the pursuit of extra riches.

Few of us really want to gamble away a happy retirement for the prospect of a few more bottles of champagne in our old age.

Accordingly, most of us should sacrifice a few tenths of a percent of return by spreading our money more widely in order to sleep better at night. It’s the same rationale as that for having a diversified portfolio that includes bonds and other low return, low volatility asset classes.

As we’ll see in my next post, you don’t want to try to pick the United States of the 21st Century, only to discover you actually invested in the equivalent of the Greeks.

1. Brazil, Russia, India and China. [↩]
2. The Credit Suisse Global Investment Returns Yearbook 2012, to be exact. [↩]
3. Basically all the biggies where they have data stretching back to 1900. [↩]

Some great reads from around the Web.

I don’t have to even pause to think what’s going to be my post of the week today – not when star pitcher Warren B. of the Omaha Value Raiders is knocking them out of the park.

In an excerpt from his upcoming shareholders’ letter in Fortune magazine, Buffett pours scorn on today’s mania for cash, and for US, German and UK government bonds with their likely desultory real yields:

Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

But before you pack your portable stove to join the gold bugs in the hills:

Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct.

Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.

So what does hard-to-satisfy Buffett like? Real assets such as shares and productive farmland, of course:

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).

[In contrast a] 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Pure passive investors will still want to hold and rebalance their chosen portfolio allocations, of course, and not dump all their bonds and any gold they have elected to carry. The idea here is to be smart by acting ‘dumb’…

…rather than being dumb like me by trying to be smart and running down your bond portfolio, only to see gilt yields drop in 2011 to almost unbelievably low levels that we’ve not seen since the 1960s.

I still think gilts are over-priced, however, and that Buffett will prove correct in the medium to long-term. He usually is.

If you were to write a novel about a super-rich investor, you’d surely have him doing all kinds of clandestine activities. Nobody could understand his trades, or how he made it look so simple.

Buffett – who is the world’s richest self-made investor – spends half his time telling anyone who will listen exactly how he does it.

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