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Investing internationally: Why is geographical diversification important?
Diversification
Along with diversifying across asset classes, stock sectors, and individual companies, investing internationally is a basic principle of investment diversification. Geographical diversification means that instead of relying on your local market, you spread your investments across different countries. This way, if one market faces challenges, others might still do well, balancing out your risks.
Of course, sometimes global equity markets move together, but there is still normally enough difference between national stock markets that this practice can offer real benefits.
What is geographical diversification?
Geographical diversification spreads investments across different regions to balance risk and improve potential returns. Essentially, instead of focusing solely on one country, investors allocate assets in multiple economies.
Markets often behave differently due to unique factors such as politics, economics, and local trends. So, a portfolio limited to one region remains vulnerable to those specific challenges. Diversifying globally ensures that while one market may face a downturn, others could thrive, potentially maintaining overall stability.
This approach also opens the door to broader opportunities. Developed economies provide steady growth, while emerging markets offer the potential for higher returns during periods of rapid expansion. Allocating resources across these areas creates a balanced and resilient investment strategy.
Geographical diversification strengthens portfolios by reducing dependence on any single economy, helping investors manage risks and take advantage of global growth.
The impact of geographical diversification (examples)
There are many advantages of geographical diversification. Let's look at a few examples of how spreading investments across international markets can potentially improve portfolio performance and reduce risks.
Example 1. Balancing European stocks with US and Asian markets
Consider an investor heavily concentrated in European equities. During a period of slow economic growth in Europe, their portfolio experiences significant losses. However, by including US technology stocks and Asian manufacturing companies, the overall impact could be mitigated. While European equities may underperform, gains from US and Asian investments could offset the downturn, leading to a more stable portfolio performance.
Example 2. 100% domestic exposure versus international diversification
Here we’ll compare two hypothetical portfolios during a European economic slowdown highlights the importance of diversification.
- Portfolio A. Invested solely in European assets, sees a 15% loss due to local market challenges.
- Portfolio B. Allocated 50% to European equities, 30% to US markets, and 20% to Asia-Pacific. This portfolio experiences only a 5% overall dip, as gains in US and Asian markets cushioned the losses.
Example 3. Emerging markets as growth drivers
Let’s say investor allocates 20% of their portfolio to emerging markets like India and Brazil. During a period of rapid industrial growth in these regions, the investor's emerging market holdings deliver returns of over 12%, outperforming developed markets. These gains significantly boost the portfolio's overall performance, even as developed markets stagnated.
Benefits of investing internationally
Investing internationally can offer potential benefits that strengthen portfolios and improve long-term financial outcomes. Here's why global investments matter:
Greater portfolio diversification
International investments reduce over-reliance on local markets. By spreading assets across different countries, investors create a portfolio that can better withstand regional economic challenges. When one country's economy faces a slowdown, another region might experience growth, helping to stabilise overall performance.
Exposure to global growth
Emerging markets often grow faster than developed economies, offering opportunities for significant returns. Countries in emerging economies with expanding middle classes and robust industrialisation present dynamic investment prospects. At the same time, established markets deliver reliable and steady growth, balancing the portfolio.
Currency diversification
Holding assets in foreign currencies helps mitigate risks associated with local currency fluctuations. For example, a European investor who includes US-denominated investments can reduce the impact of a weakening euro. Currency diversification also provides an added layer of protection during global economic shifts.
Access to unique opportunities
Some of the world's most innovative companies and industries may be based outside your home country. Investing internationally allows access to groundbreaking sectors like wind energy in Scandinavia, technology in East Asia, or healthcare in Switzerland, expanding the range of investment opportunities.
Mitigation of political and economic risks
Concentrating investments in a single country exposes investors to localised risks such as political instability or economic downturns. A globally diversified portfolio reduces the impact of these issues, ensuring that events in one region have less influence on overall returns.
Types of international investments
Investors have multiple ways to access international markets, each with unique advantages and considerations. Here are some common ones:
Mutual funds and ETFs
Mutual funds and exchange-traded funds (ETFs) simplify international investing, making them popular choices for both beginners and experienced investors. These funds pool money to invest in a diversified portfolio of global assets, offering exposure to different countries, regions, or industries.
For European investors, ETFs compliant with UCITS standards are particularly attractive due to their accessibility. Such options provide broad exposure to developed markets, while regional ETFs focus on areas such as Asia-Pacific technology or European green energy.
Direct stock investments
Buying foreign stocks directly allows investors to precisely target specific companies or industries. A reputable broker, like Saxo, can give European investors access to major international markets, including the US and Asia.
This route appeals to those who want control over their investment choices, such as purchasing shares of US technology leaders or Asian manufacturing giants.
However, direct stock investments require a deeper understanding of market dynamics, including trading hours, liquidity, and local regulations. For many, the added effort is justified by the opportunity to focus on high-potential companies.
Multinational Corporations (MNCs)
Investing in multinational corporations offers an indirect way to gain global exposure without directly investing abroad. These companies generate significant revenue from international operations, making them effective vehicles for geographical diversification.
This option particularly appeals to conservative investors who seek international exposure without exploring the complexities of foreign markets. By investing in well-established MNCs listed locally, you achieve a measure of global diversification while minimising risks associated with currency fluctuations or foreign market access.
Real estate and alternative investments
International real estate and alternative investments diversify portfolios beyond traditional stocks and bonds. Global Real Estate Investment Trusts (REITs) allow investors to participate in international property markets without owning physical assets. For example, a global REIT might focus on commercial properties across Europe or Asia.
Emerging-market infrastructure investments also provide unique opportunities, such as renewable energy projects in India or transportation developments in Latin America. While these investments often carry higher risks, they can potentially deliver significant returns during periods of economic growth.
Determining the right level of international exposure
Allocating the appropriate balance of international exposure can strengthen your portfolio by improving diversification. The optimal percentage depends on your financial goals and risk tolerance.
Here are 3 example allocations according to different risk tolerance levels:
- Conservative investors. A 15%-20% allocation offers steady diversification while minimising exposure to global market volatility.
- Balanced investors. A 30%-40% allocation provides access to growth opportunities with a moderate risk profile.
- Aggressive investors. Allocating 50% or more allows for significant growth potential, though it comes with higher risk.
Please remember these percentages serve as examples and should be tailored to individual preferences and circumstances.
Key factors in deciding international exposure
- Market behaviour. Adding assets from less-correlated regions, such as the US and Asia, helps reduce portfolio volatility during economic downturns.
- Currency considerations. Foreign currency holdings offset risks associated with domestic currency fluctuations. For example, including US dollar assets can protect against euro depreciation.
- Sector strengths. Regions excelling in specific industries, such as US technology or Asian manufacturing, offer unique growth potential.
- Risk profile. Investors with high-risk tolerance may prioritise emerging markets, while those seeking stability focus on developed economies.
Risks of international investing
International investments come with distinct risks that require careful consideration.
Currency risk
Exchange rate fluctuations affect returns. For example, when the euro appreciates against the US dollar, European investors may see reduced returns on USD-denominated investments. Currency-hedged investment options can help manage this issue.
Market accessibility
Foreign markets often have unique trading hours, liquidity levels, and restrictions for international investors. Some countries impose limits on the types of securities non-residents can purchase, complicating access.
Geopolitical and economic risks
Investing in foreign markets could involve exposure to regional political and economic challenges. For example, emerging markets, while offering high growth potential, typically carry higher risks due to less stable environments.
Higher costs
Global investments involve additional expenses, including transaction fees, currency conversion costs, and foreign tax liabilities. Using cost-efficient platforms and tax-advantaged options reduces the impact of these expenses.
Different regulatory environments
Regulatory systems in foreign markets may differ significantly, leaving investors with fewer protections or limited legal recourse. Selecting reliable platforms and understanding local regulations can reduce these risks.
Steps to start investing internationally
A successful entry into international markets requires planning and careful consideration. The steps below can provide a roadmap for getting started:
1. Define your goals and assess your risk tolerance
Establish clear objectives for international investments. Decide if the focus is on long-term growth, generating income, or both. Align these goals with your willingness to handle risk. Conservative investors may lean towards developed markets, while those open to higher risk can explore emerging markets.
2. Select the right investment option
Choose options that match your objectives:
- Mutual funds and ETFs simplify global diversification and are suitable for hands-off investors.
- Direct stock investments provide control and precision for those targeting specific companies or industries.
- Alternative investments, such as global REITs, offer diversification beyond traditional asset classes.
3. Use a reliable platform
Access to international markets requires a dependable trading platform. Saxo provides a wide range of global investment options, making it a popular choice for beginner or experienced investors.
4. Monitor and rebalance your portfolio
Review international investments regularly to ensure they align with your strategy. Rebalancing accounts for economic changes, currency fluctuations, and shifts in sector performance.
5. Stay informed about global developments
Understanding economic trends, political events, and regulatory changes can strengthen your decision-making before you invest. Knowledge of global markets reduces risks and identifies opportunities.
Conclusion: Think globally, invest wisely
Spreading investments across different countries can help protect your portfolio from the ups and downs of your local market. If one region struggles, others might still perform well, keeping your overall investments balanced.
Investing internationally also opens the door to new opportunities. Developed markets offer stability, while emerging markets bring the potential for higher returns. Including both can help you manage risks, while aiming for steady growth over time.