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Investors can, of course, invest in companies and assets in their home countries. However, can you invest overseas – and should you? As financial planners, we believe there is a strong case for “global diversification” (spreading your investments across different countries). However, why is this often a good idea, and how can investors approach global diversification wisely with their own portfolios? Below, we address these questions and offer some ideas for you to discuss with your financial adviser.
The case for global diversification
Evidence suggests that most investors have a “home bias” when picking assets for their portfolio. A 1980s study, for instance, showed that Sweden represented 1% of the world’s market capitalisation, yet Swedish investors put almost all of their money into investments in Sweden. Similar results have been demonstrated in the US and UK. The reasons for home bias are complex, yet a strong factor seems to be that investors feel “safer” with their investments being held in “familiar” domestic companies.
The risk of home bias, however, is that it puts all of your investment eggs in one basket. If a UK investor holds 95% of their portfolio in the UK, for instance, and the UK then suffers a market fall (e.g. due to a recession), then this investor’s portfolio is likely to be far more negatively affected compared to someone with investments also held overseas.
Investing globally also opens opportunities to diversify more effectively across sectors where, perhaps, your home country may not be as strong. The UK stock market (e.g. London Stock Exchange or LSE), for example, features many companies in sectors such as banking, mining and energy (oil and gas). Yet compared to the US, the UK has few technology companies like Google, Microsoft and Apple. To diversify into this sector, therefore, a UK investor may wish to gain some exposure to the US equity market.
Risks to consider
Global diversification does not completely eliminate investment risk. A bear market in the US, in particular, is likely to precede – and cause – problems in global equity markets. This is due to the sheer size of the US market, which comprises 55.9% of global market capitalisation. The UK, by comparison, comprises 4.1%.
It is also important to recognise that not all global markets pose the same risk/reward ratio. Most analysts divide national markets in “developed”, “developing” and “emerging/frontier” to describe the variations. The former, for instance, comprises the likes of the UK, US and Japan – places where the “financial infrastructure” is more reliable, but perhaps growth potential is more limited. The latter, however, might describe a country like Vietnam or Russia – markets potential to grow (e.g. due to a rapidly-expanding middle class) yet with higher risk (e.g. political factors such as government interference in the markets).
Finally, investors need to bear currency risk in mind when diversifying globally. A British investor, for example, will need to convert his/her sterling into USD when buying US-based funds. If the USD then falls against sterling, this will likely undermine your “real returns” when later selling your investments and moving the money back into sterling. However, this can work the other way around in your favour (i.e. the USD rises against sterling after you make your investment), and you can mitigate currency risk to some degree via hedging.
Ideas for investment strategy
It is worth noting that we live in a globally-connected world in 2022. Items that we consume regularly often come from overseas (e.g. footwear). In fact, about 75% of the revenue coming into the FTSE 100 comes from abroad. This is part of the reason why, as the value of sterling falls against other currencies, the FTSE 100 tends to rise (since revenues generated overseas can now “buy” more sterling at home).
As such, to some degree, global diversification cannot be avoided. Yet this does not mean that you should not consider your investment strategy carefully. A financial planner can help you to craft a portfolio which does not leave you needlessly exposed to risk, also balancing them out. For instance, there is a high correlation between the overall stock market performance of certain countries and the performance of certain sectors in the global economy.
The US is driven highly by technology (its largest sector) whilst Canada’s performance is linked heavily to energy (due to high reliance on natural resources). Japan seems to be affected heavily by performance in the global financial sector. With careful planning, a financial planner can help you navigate this wisely.
Fortunately, in today’s digital world, it has never been easier – or cheaper – to invest globally. The precise assets you choose for your portfolio, however, depend heavily on your investment horizon (timeframe), financial goals and overall risk tolerance. With some professional guidance it is possible to construct and grow a strong global portfolio that you can take confidence in.
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
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