Our world is getting increasingly smaller. Advances in technology and transport means you’re never more than a few hours away from anywhere in the world. From an investment perspective, you can access any market in the world. Thanks to the harmonisation of international financial markets and investment product innovations, you’re able to put your money into different countries and asset classes and access a myriad of investment strategies.
But any increase in choice raises questions: how should you balance your portfolio between home country based investments and international assets? You could argue that any money in the domestic environment is more relevant to your day-to-day life, but will you be missing opportunities in the broader global market? Could diversification ultimately lead to stronger returns?
Adjusting domestic and international allocations isn’t an easy task. Investors tend to suffer from “home country bias”, which is the tendency to invest predominately in your domestic market due to uncertainty about – or simply fear of – investing in foreign markets.
Where does home country bias come from?
According to behavioural economists, investors are more comfortable with the familiar. Primarily we tend to “invest in what we know”. For example, an investor based in Europe may be put off some emerging markets by negative headlines regarding accounting standards, corporate governance, government intervention and liquidity concerns.
Additionally, institutions such as pension funds, are more likely to allocate assets heavily in domestic markets. They’re likely to focus on fixed income allocation; the inflation environment and economic strength of the home market is most relevant to the individual holding that pension.
However, despite this, there is evidence to show that a home country bias can lead to sub-optimal portfolio allocation with higher risks and lower returns. You could miss out on the potential benefits of having a globally diversified portfolio, especially in today’s world where there can sometimes be a high degree of correlation between the different asset classes in a single market.
The risk and reward of having a global portfolio
Exposure to global markets can reduce overall portfolio risk and dampen volatility through greater diversification and lower correlations among investments. International investing can literally open up a “world” of opportunities, giving you access to economies that are often growing at a faster pace than the UK.
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Thanks to the development in the exchange traded fund (ETF) market, you can now access markets and asset classes that were previously expensive to invest in. This allows you to efficiently construct a globally diversified portfolio at a lower cost than investing in a global allocation mutual fund.
By broadening your investment horizon to go beyond the domestic border, you can, to some extent, protect your wealth from domestic cycles and potential valuation traps. As the valuation of developed market equities, as well as bonds, reach historical highs, many other markets such as emerging countries are now appearing to be more attractively priced than their developed market counterparts.
Yet investing in global markets does mean investors are exposed to more risk factors. Over the past few years risk factors, such as geopolitical clashes in the Middle East, earthquakes in Japan and debt crises in Greece, have all significantly impacted global portfolios. Additionally, a globally diversified portfolio also comes with greater currency risk, as the fluctuation in exchange rates can impact the overall portfolio’s performance in relation to the home currency.
When thinking about domestic and international exposure in a portfolio, you should note that some domestically listed multinational companies derive a significant part of their revenues from outside of their home country. A good example of this is Unilever, a British-Dutch consumer product company, it’s listed shares are by definition a developed market equity investment. However, the majority of the firm’s revenue is coming from emerging economies in Asia, making it more exposed to risks outside of the home country.
Similarly, Samsung, the South Korean multinational conglomerate, has a customer base that is highly concentrated in developed economies, therefore making it more like a developed market equity investment than an emerging market stock.
As the world becomes more inter-connected, it’s important to consider the case for international investing and really understand the underlying risk associated with each investment. The goal of a globally diversified portfolio is not the collection of stocks and bonds from different parts of the world, but rather balancing the risks in the portfolio to protect and grow your wealth through time.