Since no individual or institution has the financial or logistical capacity to invest in all stocks, there’s always a risk that the shares bought will underperform or, in the worst case, completely collapse, thus eroding net worth.
Fortunately, there are a number of steps investors can take to manage investments and minimize the impact of market setbacks and volatility. Perhaps the most important among these steps is global investment diversification.
What is Investment Diversification?
Diversification is a vital tool for investment risk management. It involves holding assets that fall in multiple classes each expected to behave differently when exposed to certain market conditions and economic events.
Diversification means spreading risk by investing across asset classes (e.g. stocks, mutual funds, treasuries, bonds, metals, commodities, cash or real estate) and within classes (e.g. buying shares in multiple industries).
A common mistake investors make is to conflate ownership of a large number of different stocks with having a diversified portfolio. For instance, holding the stock of several banks all operating in the same market is actually a concentration of risk. Chances are that in the event of major economic swings, the stocks of these banks will move in the same direction.
Even index tracking funds are not necessarily diversified. The stocks are often exposed to the same market. While the shares that comprise an S&P 500 Index fund for instance may move in different directions many times, they will likely be similarly affected by major macroeconomic incidents.
Benefits of Diversified Investments
Diversification has a number of advantages:
- Reduce Losses – The losses experienced by the price decline of some stocks will usually be covered by gains from other assets in a diversified portfolio.
- Consistent Long-Term Growth – A diversified investment portfolio will see steady, albeit sometimes modest growth, over the long-term. Even during difficult periods, a diversified portfolio will quickly recover and return to positive territory.
- Spreading Risks – No investment category consistently outperforms other categories. All asset classes experience peaks and troughs. Holding assets across different classes means you are not solely banking on any one asset.
- Peace of Mind – The daily and weekly price swings of individual assets can cause substantial emotional toil. If you have invested all your retirement savings in one stock, you are constantly worried about your financial security if the company were collapsed by an ethics scandal, driven out of business by competitors or failed to meet its growth targets. Diversification minimizes portfolio volatility and gives you peace of mind.
What is Global Investing?
Global investing is the international spread of investment assets and is a means of portfolio diversification. Home bias, an investor’s tendency to only buy assets domiciled in their home country, is a fairly widespread occurrence. There is an underlying safety and predictability in the familiar so this aversion to foreign markets is not surprising.
Yet, home bias robs investors of the potential gains from global investing. Even for the United States which hosts the largest stock markets in the world by market capitalization, investors who focus on the U.S. alone miss out on the global pie. As at October 2016, the market cap of U.S. stocks was 36 percent of global market cap, a decline from 45 percent in October 2003.
Note that investing globally is not of itself a guarantee that a portfolio is sufficiently diversified. For instance, buying banking stocks in different countries is still risk concentration. If an adverse international economic event such as the 2007-2008 Global Financial Crisis were to strike, bank stocks in nearly all major economies would be impacted negatively.
Benefits of Global Investing
The advantages of global investing are similar to the benefits of diversified investment listed earlier. In addition, global investing has the following going for it:
- Mitigate Against Political and Sovereign Risk – National governments routinely make decisions that affect the business and investment climate in the country. Global investing ensures you are never completely at the mercy of any one jurisdiction.
- Cushion Gains From Currency Swings – The U.S. Dollar has remained the preferred currency for international investing and business for decades. Yet, despite its relative stability, the dollar is not immune to currency movement. Global investing exposes your portfolio to multiple internationally traded currencies.
- More Balanced Exposure to Multiple Industries – As at March 31, 2017, five of the 10 largest stocks by market value in the U.S. are technology stocks (Apple, Alphabet, Microsoft, Amazon and Facebook). This is unusual compared to other economies. A portfolio that is comprised of U.S. companies alone is likely to be underweighted in traditional sectors such as automobiles, household goods and electrical equipment.
- More Consistent Performance – U.S. and international equities usually alternate in performance. For example, a bull market in America is often accompanied by slower returns or stagnation in Europe. The reverse is also often true.
Multinational vs. International Company Investing
Buying stocks of multinational businesses provides some degree of foreign exposure. It is however more beneficial to invest in international equities. Here’s why.
- Most multinationals derive the bulk of their revenue from their home market. The movement of the firm’s share price is likely to track domestic performance more than any exceptional returns realized in foreign countries. Even where a company has the majority of its revenue earned in other markets, this principle may still hold true since the majority of shareholders are from the home market and primarily react to local events.
- Foreign currency can be a powerful agent of diversification. This advantage is however lost when you hold multinational equities. Most of such companies hedge against currency fluctuations in the foreign countries they operate in.
Global Investing Tips
There are a number of ways you can purchase foreign assets.
- Invest in mutual funds or exchange-traded funds (ETFs) that track the stock market indices of multiple countries.
- Life-cycle or target-date funds that automatically include a certain percentage of foreign assets. This is particularly useful for the more passive investor.
- American Depositary Receipts (ADRs) are a convenient alternative especially if you only want to deal in U.S. dollars. American banks buy shares in a foreign corporation, bundle and issue them to U.S. investors. No currency conversion is required.
How Much Should I Invest Globally?
How much you invest internationally depends on your overall goals. It is recommended that investors set aside 25 to 30 percent of their portfolio to global stocks. Less risk averse parties may be more comfortable with as much as 50 percent of their assets being foreign. For the average individual, the weighting of foreign assets in their portfolio should decline to 20 percent or lower as they approach retirement age.
Emerging markets have higher volatility and inflation than developed markets, and are not suitable for the more conservative investor. That being said, since individual emerging markets have minimal correlation to each other, investing across multiple emerging countries reduces this risk.
Conclusion
As the world’s economies become more interdependent, it’s increasingly difficult to draw a definitive line between domestic and foreign assets. Also, an increasing number of multinationals draw a significant proportion of their revenue from outside their home markets. Some of the larger mutual funds include some foreign stocks in their holdings.
Ergo, many investors are exposed to international stocks even though they did not deliberately set out to do so. That’s why before developing an investment diversification plan, it’s important to evaluate your assets in order to have an accurate picture of the international exposure of your existing portfolio.
Global diversification is vital if you want to reap the benefits of growth from different parts of the world. Whereas there’s no single formula for investment success, diversification is, in the long run, a robust defense against volatility and a safe path to sustainable growth and returns.