What is Geographical diversification, and why is it important?
Geographical diversification is assigning money to a diverse range of investments to minimize risk. It’s akin to not placing eggs in one basket in terms of money.
Purchasing securities from numerous locations is called geographical diversification. Like many advisors may have advised you against keeping all your money in one stock, similarly, you don’t want all your money in one single country or region. Relying on one single means that the stock’s failure would be devastating to your portfolio.
Geographic diversification, like general diversification, is based on the idea that stock markets in different regions aren’t always highly associated.
For example, suppose the stock markets in advanced economies are decreasing due to a recession. In that case, an investor may transfer a portion of his or her holdings to emerging economies with greater growth rates, like China, Brazil, India, Russia, and others. This strategy restores balance to your portfolio.
The pros and cons of global diversification
Expanding a portfolio across several geographic locations can help investors adjust for the fluctuations of a particular financial region, lowering risk over time compared to less diversified portfolios.
Investing in international markets has never been easier, thanks to exchanging traded funds and mutual funds.
| Pros of Global Investment Diversification | Cons of Global Investment Diversification |
|---|---|
| 1. Risk Reduction: Spreading investments across various regions helps mitigate risks associated with economic downturns in any single market. | 1. Currency Risk: Fluctuations in exchange rates can impact returns negatively, especially if the domestic currency appreciates. |
| 2. Enhanced Growth Potential: Access to emerging markets and industries can lead to higher returns compared to domestic investments. | 2. Higher Transaction Costs: Investing internationally often incurs additional fees and costs, such as currency conversion and higher brokerage fees. |
| 3. Access to Unique Opportunities: Different markets offer unique sectors and companies not available domestically, broadening investment horizons. | 3. Political and Economic Risks: Investments may be affected by geopolitical tensions, political instability, or economic downturns in foreign countries. |
| 4. Portfolio Resilience: A diversified portfolio is better equipped to handle global economic changes and market volatility. | 4. Market Liquidity Issues: Some international markets may have lower liquidity, making it harder to buy or sell investments without affecting prices. |
| 5. Currency Diversification: Holding assets in multiple currencies can provide a buffer against inflation and currency depreciation at home. | 5. Complexity of Management: Managing a globally diversified portfolio requires more research and understanding of different markets, which can be challenging for investors. |
Diversifying away from advanced economies has its compensations. Many enterprises in sophisticated markets offer comparable products and services, resulting in fierce competition. On the other hand, developing markets may be less competitive and hence have more room for expansion.
The refute is that the whole world’s marketplace is already interconnected, so dispersing your money across different areas no longer provides the same level of diversification.
Compared to industrialized countries, faster-growing economies may face higher political risk, currency fluctuations, and general market risk.
Exchange rates, for instance, are always changing and can work against you. If the rupee declines, an investment in India, for example, could lose value in dollar terms (This means it takes more rupees to buy a dollar).
On the other hand, investing in different currencies is another strategy to diversify and reduce risk.
Over the previous ten years, India’s share market has generated remarkable gains. It is one of the world’s fastest-growing stock markets, outpacing even the S&P 500. For instance, from August 08’ to August 18, the S&P 500 Index increased by 142%, whereas the BSE SENSEX climbed by 188%.
Despite greater return, the SENSEX shows high volatility. Volatility means how risky a particular investment is for the average investor. The risk of the investment is, the greater the volatility the more price movements there are.
The standard deviation of the return is one measure of volatility. Compared to the S&P 500, the SENSEX has more spells of higher volatility.
Minimizing volatility when designing a portfolio can result in a more profitable portfolio. This is the basic argument of the Modern Portfolio Theory, which states that an investor should opt to maximize return for a given level of risk rather than taking a greater risk that would not provide additional gains.
In general, geographical diversification promotes more stable investment returns while lowering the depth and duration of your portfolio’s drawdowns compared to other regional markets.
Given the current state of world geopolitics, which could lead to more diverse outcomes in country investment returns and relatively close to nil interest rates globally, resulting in lower asset yields in the future, geographical diversification is important.
In fact, geographical diversification of your investment portfolio may be the best chance of successfully conserving and growing your wealth for the future.
FAQs
What are the benefits of geographical diversification?
Geographical diversification offers numerous benefits that can enhance your investment strategy. By investing in different geographic regions, you can minimize risks and potentially improve returns.
It allows you to tap into markets with greater growth potential, like emerging economies such as India and China, which may offer unique investment opportunities.
Additionally, geographical diversification helps mitigate the impact of localized economic downturns, political instability, and other region-specific risks.
How can I effectively achieve geographical diversification?
To achieve geographical diversification, you can employ various investment strategies. One approach is to invest in mutual funds or exchange-traded funds (ETFs) that focus on specific regions or global markets.
These funds typically consist of a diversified portfolio of securities from different countries, offering exposure to multiple regions in a single investment.
Another option is to directly invest in foreign stocks through international brokerage accounts. This allows you to handpick individual stocks from different countries based on your research and risk tolerance.
Regardless of your chosen method, it is crucial to thoroughly assess the investment options, understands the regulations and taxation aspects of each region, and consider seeking advice from financial professionals to ensure effective diversification and risk management.
What are the potential risks associated with geographical diversification?
While geographical diversification offers various benefits, it’s important to be aware of the potential risks involved.
One risk is currency fluctuations, which can impact the value of your investments when dealing with foreign markets. Changes in exchange rates can either amplify or diminish returns.
Additionally, investing in regions with unstable political systems may increase the risk of unexpected policy changes or social unrest, which can affect market stability.
It’s crucial to conduct thorough research and stay informed about the specific risks associated with the regions you intend to invest in.
