I'm all for diversification. The last few years have shown the value of having your investment capital well diversified, beyond the local stock and bond markets. Many people have turned to investing overseas and that can be a sound diversification strategy. But it is also clear that far too many are doing so blindly. People seem to be more willing to accept risks that are nonquantifiable and difficult to prove than those that are more readily at hand.
Studies have shown that people's perception of risk is often misguided and inconsistent. The classic economic example is that people prefer a certain win of $100 over a 50% chance of winning $200 or winning nothing. But in reverse, they prefer the 50% chance of losing $200 or losing nothing over a certain loss of $100. When it comes to investments with limited information versus those with more information, I think people's risk perceptions are often similarly skewed. In the situation of indefinable and therefore unlimited upside potential, investors willingly ignore the equally unclear risks.
In a recent short-lived endeavor, I did a great deal of research into investing in Chinese companies and even constructed an index to track those offering American Depository Receipts (ADRs). It's not something I'm proud of, and it's one of the reasons among many that I'm no longer with that outfit. The Chinese ADRs I tracked are now down more than 25% for the year.
These investment vehicles have been highly popularized recently with big IPOs such as Ctrip.com (Nasdaq: CTRP ) , China Life (NYSE: LFC ) , and NetEase.com (Nasdaq: NTES ) . But the deeper I dug into such companies, the longer the list of risks got. There are, quite simply, so few controls that Chinese companies are not at all comparable to U.S. companies. The definition of a public company does not mean the same thing.
My advice is that if you're going to gamble on such dubious things, then do so through an open-ended fund that invests directly in foreign stocks rather than the limited number of companies that happen to have ADRs trading here, likely at a premium to the underlying stocks. That way, you at least have some decent diversification and a modicum of chance that some due diligence has been done. But stick close to home if you are not knowledgeable about the risks involved.
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Fool contributor Mark Mahorney doesn't own shares of any companies mentioned.