The vast majority of investors in the United States have a very high percent – or even 100 percent – of their Equity holdings in Domestic Equities. While this emphasis on U.S. stocks is understandable, an investor should ideally have investments outside of the U.S. as well.
Why is this? Investments always involve risks, and in markets as volatile as the ones we find ourselves in, there is a need to create stable risk management profiles.
From this need arise numerous investment strategies that center on the diversification of stock portfolios. In this article, we turn our focus to one particular form of diversification strategy: Global Diversification. This concept refers essentially to spreading your portfolio allocation by investing in various markets from other countries to maximize returns and balance your losses.
What exactly do we mean by Diversification?
We discussed general diversification in our last article on sector diversification. Given how important understanding diversification is, here’s a refresher of our discussion.
When we talk about diversification, we primarily discuss the investment strategy whereby stocks are spread across sectors or regions. The basic idea behind diversifying a portfolio is to achieve greater risk management. “Putting all your eggs in one basket” is a strategy that can make an investor a victim to unrelenting market volatility.
In the modern world, unsystematic or unplanned risks have become quite common due to the ever-changing nature of development. This refers to unforeseen or unintended market changes or trends. In such a scenario, it is deemed important to balance your risks against your potential rewards.
In the language of finance, it’s often quoted that “Diversification is the only Free Lunch.” You can invest outside U.S. stocks and allocate capital to developing industries and international stocks to dilute your risks.
Most financial experts agree that diversification of stock portfolios is necessary for long-term growth strategies. In general, diversification strategies exist to dilute your risks and maximize your returns. They provide a barrier of protection that would not exist under a concentrated stock portfolio. In particular, Global Diversification can also help investors escape localized bubbles or market crashes.
Global Diversification Strategy
This strategy refers to a particular form of diversification whereby stock portfolios are allocated to international and emerging market stocks. Proper long-term investment requires not only planning but a broad worldview. U.S stocks account only for around 50% of the stocks in the global economy as weighted by market capitalization (in U.S. Dollar terms).
On the other hand, there is a whole world of developing and growing economies with their stocks and valuable assets. Additionally, in a world of such inter-connectedness and globalization, investors cannot possibly disregard the economic developments beyond their national boundaries. For this reason, modern finance portfolio theory has begun to emphasize the use of this strategy in creating portfolios that adapt to these conditions and opportunities.
The Global Diversification strategy believes that different international entities react differently to similar events. For example, the decade encompassing the first ten years of the 21st century is referred to as “the lost decade” for investors. This is because the Standard & Poor’s 500 Index, a well-known benchmark representing U.S. Large-Capitalization stocks, experienced an unprecedented plummet in its value following the “Dot Com” crash of the early 2000s.
In contrast, most major International Developed and Emerging Market indexes outperformed the S&P 500 during that lost decade. For financial experts, investors who diversified their stock holdings along regional lines were not as affected by the decline in U.S equities as much as those who invested exclusively within the borders of the United States. For Registered Investment Advisors such as RVW Wealth, this strategy is an essential component for investors who value the security of their investments.
Advantages of Global Diversification Strategies
With that said, let us now discuss the specific reasons why Global Diversification is a vital tool for investment strategy. These reasons include:
1) Diluted Risk
Here it is: the most obvious reasoning for any form of diversification lies in the need to dilute or balance out risks. The same goes for the Global Diversification strategy. Many financial experts believe that International Equities have the potential to perform better than U.S. Equities do in the coming years. This can be due in part to the elevated valuations (e.g., Price/Earnings) we are seeing in U.S. stocks in recent years.
There is no doubt that the second decade of the 21st century has been a decade of growth for the U.S. One might say: “Why should an investor disregard the benefits of this growth and diversify amongst international stocks, which may be even more volatile owing to political circumstances?”
This is a valid question, but one cannot judge market performance based solely on historical precedence. We live in an interconnected and globalized world that is changing unevenly and rapidly.
It is prudent for investors to diversify their stocks along global lines; after all, what’s the loss in minimizing risk? A globally diversified stock portfolio is bound to dilute the risks from domestic market shocks and volatilities.
Proper analytical research is required before global investments, but the consequences can be quite advantageous. Simply put, it helps reduce the effects of market volatility on individual investments, all while creating conditions of long-term risk aversion for stockholders.
For these reasons, spreading out your investments and having international holdings from developing economies such as India or China can be quite advantageous. Such economies provide great potential for growth and help offset any declines that may appear in U.S stock values. The current economic war between China and the U.S provides investors with the opportunity to play both sides to minimize their risks.
2) Wide Range of Options and Greater Security
Suppose that you’ve created a stock portfolio that is centered on a particular theme or cause. Furthermore, suppose you are quite passionate about Green Technology and want to contribute to its development. Given these two inputs, Global diversification strategies allow you to create a stock portfolio that integrates multiple different international companies that share similar themes or causes.
Asides from that, these strategies offer investors with lower investable amounts the opportunity to diversify their stock portfolios into international companies with greater clout and financial stability. It allows them to escape their politically volatile climate and invest in developed markets.
In contrast, these strategies also allow investors from developed economies to invest in various emerging markets that can offer potentially greater returns. After all, if a developed economy stagnates, returns may not be as fruitful as they would be within a n emerging economy that prioritizes shareholder returns.
In addition to this, global diversification offers you security on your investments and protects against fraud and liquidation. Global transactions are usually conducted through international financial institutions that are very reliable and have strong regulations in place. Ironically, it would be easier to be victim to threats of seizure or liquidation within a domestic stock portfolio than if you hold a globally diversified one.
3) Currency Diversification
Another major benefit of Global Diversification is that stock portfolios can be beneficiaries of currency appreciation. It is a fact that emerging markets usually have depreciating currency rates. So investors are potentially benefiting from greater stock returns and through currency appreciation upon the selling of those stocks.
What’s the importance of Global Diversification in the current day and age?
Now, let us get to the heart of this article. We have discussed the concepts and strategies of global diversification alongside its benefits. You may therefore ask: What is the significance of such a stock portfolio strategy in the 21st century?
Consider this: most global equity shares exist outside of the U.S., and these equity shares operate upon their logic, political conditions, and economic policies. For example, while the lost decade saw a massive decline in U.S stock market values, the international markets saw greater returns and profits.
Extrapolating this time map to the last eleven decades, we find that the U.S was the best performer for only five of those decades. For the remaining six decades, the U.S wasn’t anywhere near the top. This means that market volatility creates major risks when a stock portfolio is concentrated amongst a domestic market. Again, this proves the historical need for a strategy that can dilute this issue and allow investors to take advantage of growth trends in other countries.
Lastly, as the world integrates itself economically and politically, investors require strategies such as Global Diversification to adapt themselves to this new climate. This means that investors must not shy away from discussing the various facets of developing markets, and they must at a minimum have exposure to these markets to take advantage of their unique developments.
In summary, Global Diversification is a key strategy in the modern-day world of investing. Such a diversification strategy allows portfolios to extend their reach across geographical lines, diluting their risks, and providing more exciting avenues for growth and returns.
This strategy is advocated by firms such as RVW Wealth and other management firms that prioritize individual investor needs and requirements, as well as an exciting opportunity for investors to reach out and integrate themselves into the globalized economy.
August 27, 2021