Investing overseas can provide U.S.-based investors with some protection and diversification for their portfolios, but it isn’t the panacea that many assume. While this strategy can provide securities with a lower correlation to U.S. stocks as well as some protection against U.S. economic downturn, globalization has made true diversification more difficult to achieve. Read on to find out more. (To read more about diversification and how to obtain it, see Introduction to Diversification .)

Dependence On U.S. Dollars

There have been many periods throughout time when foreign markets have outperformed U.S. markets and vice versa. However, by and large, these markets are still intimately connected and can have a high degree of correlation. (For related reading, see Investing Beyond Your Borders .)

Remember that Americans are big consumers. They purchase a wide variety of goods, ranging from cars and electronics, to consumer products that originate outside of the United States. However, if Americans were suddenly to curtail their spending, the economies of many countries would take a hit because it’s likely they would sell fewer goods and services; as a result, their equity markets may decline.

To put this issue into a better perspective, a March 2007 International Herald Tribune article quotes a Morgan Stanley analyst as saying t he United States accounts for 24% of Japan’s total exports. 84% of Canada’s, 86% of Mexico’s and about 40% of China’s. In other words, if U.S. stocks are suffering from a lack of consumer spending, this effect may also resonate in foreign stocks.

Lack of Innovation Can Hurt

During flush economic times, U.S. companies have a tendency to spend gobs of money on research and development. In fact, the manpower and dollars that have been spent on development projects over the years is a major reason why the U.S. has been a major center for innovation and commerce for the past century. (For related reading, see Buying Into R&D and Which Is Better: Dominance Or Innovation? )

However, when U.S.-based companies struggle to make ends meet and to generate even meager profits for their investors, they tend to go into a defensive mode. In other words, they don’t expand, take chances, or initiate new major product launches. They literally hibernate like a bear in the winter time. This can have an adverse impact on some overseas companies.

For example, let’s say that Dell (Nasdaq:DELL ), the well-known computer maker, doesn’t have the money to launch and market a new type of computer. As a result, the company puts this project off indefinitely. Some people might assume that this problem will be limited to Dell and its shareholders. However, what happens to the folks that make the semiconductors overseas (in Korea) or the distributors and/or shipping companies that would have handled the product launch? The fact is, their businesses suffer as well.

Another terrific example can be found in the auto industry. Let’s suppose U.S. consumers curtailed their spending, and Ford (NYSE:F ) responded by curtailing its spending. While many might assume that the damage would be limited to Ford and its shareholders, overseas part makers that produce many of the parts that go into Ford vehicles will suffer as well. The Mustang, for example, is a good old-fashioned muscle car and a staple of American society for decades. According to a September 2006 report in the Chicago Tribune. the vehicle has a domestic parts content of only about 65%, which means that up to 35% of its parts are manufactured outside the U.S. If fewer Mustangs are sold, this will affect the foreign companies that supply those Mustang parts.

Less Travel Equals Fewer Dollars

When the U.S. economy is booming and the dollar is trading at a premium to, say, the euro or the Japanese yen, U.S. consumers will be more apt to travel to those regions because their dollars will be able to buy more goods and services overseas.

However, when the euro or the yen or rise against the U.S. dollar and the U.S. economy is in a rut, fewer people will travel to those areas because the dollar will buy less. Therefore, perhaps not surprisingly, during recessionary periods or prolonged periods of slow economic expansion, a lack of U.S consumer spending and travel can have an adverse impact on tourism-related businesses (such as hotels and restaurants) overseas. (Find out how a currency’s relative value reflects a country’s economic health in Forces Behind Exchange Rates .)

In a 2003 report, Dirk Belau of the International Labor Organization points out in a report how millions of tourism and travel jobs were affected by the attacks on the U.S. that occurred on September 11, 2008, a period in which few Americans traveled abroad. As a result, some countries saw marked slowdowns in tourist traffic. (For more insight, check out Terrorism’s Effects On Wall Street .)

Protectionism Could Take Hold

When the domestic economy struggles, some politicians may push for tariffs on imports (in order to support U.S. companies and protect American jobs). Such efforts can have a dramatic impact on overseas companies. Higher tariffs can translate into higher prices for the end good at the retail level, meaning consumers may buy less. Again, remember that many countries are heavily dependent on the U.S. as a trading partner, so even a slight decline in U.S. demand for overseas products can negatively impact other economies.

Over the long haul, tariffs may also end up hurting U.S. companies as well, because other countries may then raise taxes on U.S.-produced goods as retribution.

Asset Valuation Issues

During a U.S. economic slowdown, foreign companies that own property in the U.S. or stakes in U.S. equities could see those values decline markedly. This in turn could have an adverse impact on the financial statements or performance of those overseas companies (particularly those that depend on the cash flow generated from those investments). By extension, it could adversely impact foreign stock prices as well. (For related reading, see Why would a multinational corporation conduct a vertical foreign direct investment? )

Bottom Line

Overseas investing can provide an investor with additional diversification, and can be a good thing. However, it may not be the cure-all that some think it is because of the fact that the American economy is so highly correlated with other major economies throughout the world.