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5 Disadvantages of Investing in Foreign Index Funds

Investing in foreign index funds can be a risky way to begin investing in mutual funds. Many first-time investors in the financial markets want to swing for the fences and make an investment that's going to net them a lot of money right away, but that isn't the best approach for young investors who don't yet have a solid foundation under them. While diversifying your investment portfolio is a good thing, and including some foreign index funds is a good way to mitigate the risk, there are often serious disadvantages to putting your money into foreign markets.

Political Risks

Many governments overseas are politically and financially unstable. They could be facing unrest with their own citizenry, or they could nationalize an industry that you're investing in, rendering it obsolete. Many foreign governments also lack strong economic laws that can help correct market instabilities. While the reward is great for investing in a foreign fund that takes off quickly, such companies can often be derailed by their own governments. If you want to invest abroad, do research on the country first to determine if it's a friendly business climate.

Unstable Currency

Even in the United States, the value of currency can experience drastic highs and lows. Economic downturns often trigger inflation, which boosts the price of goods and devalues spending power. However, the U.S. has many laws and policies in place that can help to offset inflation and other fluctuations in the market, and many foreign countries do not. Also, the value of many foreign currencies is tied to world powers like the U.S. dollar or the Euro, which means that an economic crisis in one country can drag down the value of currency across the world. Investing in emerging markets means tying your investment to frequently very unstable currency, which dramatically increases your personal risk.

Bad for Beginners

The first instinct of many first-time investors is to try to get rich as quickly as possible in the markets. While this can be effective, for the overwhelming majority of investors, it's a poor financial decision. In order to take big gambles in the market, you first have to create a solid financial foundation for yourself. This means an emergency savings account of at least three to six months-worth of income and some long-term, conservative investments in your portfolio. Only then should you start thinking about taking risks in emerging markets.

High Expense

The expenses that go along with managing U.S. stocks are lower than many investors think. Because of the relative strength and stability of the market, there is simply less of an expense ratio built into your investment costs. However, foreign index funds can charge you more money for their maintenance and handling. The instability of the markets plus the turnover in fund management means that you'll often pay more in trading fees than you would dealing in a domestic market. This is also because the rate of return on your investment in a foreign index fund is expected to be higher.

Over-Concentration

One of the greatest risks in investing in a foreign index fund is the risk of putting all of your eggs in one basket. Many foreign markets are tied to each other, so if you invest heavily in China and another Pacific Rim country suffers a financial meltdown, your investment will take a massive hit. You run the risk of exposing yourself to over-concentrated investments overseas when you put your money into index funds abroad. This can pay huge dividends if a region of the world takes off in a big way, but more than likely it will cost you in the long run. Consider this when you're wondering how to invest in mutual funds.

Investing in foreign index funds is an aggressive financial strategy, though it isn't one that's necessarily well suited for first-time or beginning investors. Foreign countries can be politically unstable, have their currency tied to other unstable markets, and can even cost you more in administration fees. Before you take the risk of investing your money overseas, consider setting up a long-term and more risk-averse financial strategy. Only then should you think about taking bigger chances with your portfolio.

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