Retirees depend on their investments as a source of income, so it's not surprising that most are highly risk-averse. And because many perceive foreign stocks as being riskier than their U.S. counterparts, many retirees shun foreign stocks in their portfolios. But retirees should own foreign stocks, because by investing only in U.S. stocks, they actually take on more risk.

Diversify, diversify, diversify

Over and over again, diversification has proven to be one of the most effective ways to reduce overall risk in any investment portfolio. The more you spread your purchases out over investments that react differently to different external events, the more likely you are to have a portfolio that will show some gains no matter what happens.

Picking up a few foreign stocks to supplement your domestic ones is a key part of any good diversification strategy. An event that drives down the U.S. stock market as a whole may have no effect on other markets, or may even cause them to boom. Thus, foreign stocks can protect you in ways that no domestic stock can.

Earth as seen from space

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Not all foreign stocks are created equal

The world market as a whole can be roughly divided into developed markets and emerging markets. Nations that already enjoy large market capitalizations, reasonable political stability, strong financial regulation, and relatively high per-capita incomes typically fall into the developed markets category. Canada, Australia, the United Kingdom, New Zealand, and Japan are all great examples of developed markets. Other nations, particularly ones with relatively new markets or infrastructures that are experiencing rapid growth, typically fall into the emerging market category. The BRIC nations -- Brazil, Russia, India, and China -- are among the most popular emerging markets.

Investments in emerging markets are likely to be riskier and more volatile than investments in developed markets. However, emerging markets also offer greater opportunities for growth. Because these nations are growing rapidly, the investments you make in them can also grow rapidly. While retirees won't want to put a lot of money into such a volatile sector, putting a small investment in an emerging market stock can help boost your overall returns a bit.

There's an index fund for that

Index funds and ETFs that specialize in foreign stocks and bonds are a great way for retirees to diversify in that direction while minimizing risk. The simplest way to add some foreign stock exposure to your portfolio is to buy a few shares of a fund that spreads its investments out over the entire globe, or the entire world outside the U.S. If you'd like to customize your foreign investments a bit, consider picking up two different foreign stock index funds: one that owns emerging market stocks and another that owns developed market stocks. Buying these two funds will allow you to decide for yourself how you want to allocate your investments between the two types of markets.

How much foreign stock should you own?

Because most retirees already own blue-chip U.S. stocks (either individually or within their mutual fund holdings) that have operations around the world, they already have some globalization built into their portfolios. Thus, it doesn't take much foreign stock to give you ample diversification. Putting 10% to 20% of your stock money into foreign stocks is enough to get the benefits of a diversified portfolio. You can reduce volatility by keeping the majority of your foreign stocks in developed markets. And if you start having trouble sleeping at night because you're fretting over your portfolio, reduce your foreign exposure until you feel safe again.