What is “International Diversification”?
International diversification is a risk management technique that aims to reduce volatility by spreading the risk across multiple geographical regions. This means not only investing in securities of companies that operate in different sectors and differ in size and style, but also allocating assets across different locations and countries. These countries would typically show a low correlation and react differently to market and economic events. This is designed to reduce the volatility of the portfolio’s returns over the long-term. Adding foreign exposure to a portfolio could also help reduce a number of additional country-specific risks such as economic, political, local market and currency.
Key Learning Points
- Investors often focus on investing in different asset types, sectors, company sizes, and styles, but adding international diversification could further reduce risk
- Diversifying globally could potentially offer investors a smoother journey over the long-term
- Investing across multiple geographies and markets that show a lower correlation and react differently to market events is key for international diversification
- Gaining international exposure can also reduce the risks of currency movements as well as shifts in the political, economic or regulatory climate
Why International Diversification?
Companies normally tend to act and build their strategy in accordance with their country of domicile. However some investors could argue that investing in US or UK large cap companies already brings global diversification as nearly half the revenues of S&P 500 companies and around 75% of those in the FTSE 100 index derive from overseas operations. As a result, these companies also tend to respond to domestic economic and political events more actively compared to those outside their country of domicile.
In addition, the economies of different countries could also tilt towards one (or a few) sectors – for example the FTSE 100 is heavily dominated by Oil majors, Mining and Financial companies, while Technology has a weaker overall presence. International diversification would help to mitigate this.
What Are the Risks?
Investors should bear in mind that although international diversification is expected to be supportive for returns over the long-term, gaining exposure to foreign companies may also expose the portfolio to risks that are not existing in investors’ home country. For example:
- Currency risk – the risk of making a financial loss as a result of exchange rate movements
- For example, should the US Dollar become cheaper relative to the British Pound, the investor’s US holdings will be worth less in British Pounds
- Foreign investment risk – i.e. the possibility of making a loss when investing in foreign countries
- For example, if a US investor buys company stock in emerging markets, he or she might face risks that do not exist in their domestic country such as the risk of nationalization
- Political risk – changes to the political climate in a country occur may directly or indirectly impact inflation and interest rates, and the country’s market
The Bottom Line
No single country can outperform all the time and therefore international diversification can help spread risk across different regions, countries, sectors, currencies and companies. Furthermore, even the impact of unexpected risks and events such as unusual weather patterns or natural disasters could be limited by having a global exposure.