I have been an advocate of portfolio diversification as a means to cushion your portfolio from adverse market conditions. As I have indicated in my earlier articles on portfolio diversification, diversification can be among asset classes, across geographical locations, or across industry types.
What is diversification?
You may have heard the statement, don’t put all your eggs in one basket. In finance and investment and indeed in all walks of life, that statement is self-evident because by putting all your eggs in one basket, there is a greater risk of losing all the eggs, should something bad happen to the basket. On the other hand, if you put your eggs in many baskets, you still have other baskets to fall back on, should anything bad happen to one of the baskets. The investment term to describe putting your eggs in many baskets is portfolio diversification.
Analysts and experts believe that a well-diversified portfolio should include international or foreign securities. Unfortunately, many investors are suffering from what may be called home-country bias in their investment decisions. Home-country bias is the tendency for investors to invest in their home countries, rather than in foreign countries. But why is it advantageous to add international or foreign securities in your portfolio? Here are the major reasons or advantages:
One reason to diversify across the borders by adding international securities is the need to minimize portfolio risk. This risk-minimizing benefit arises from the low correlation that may exist between domestic securities and foreign or international securities. The low correlation is due to the fact that domestic and international securities are exposed to different economic and market conditions and as such, trend differently.
Adding international or foreign securities has the tendency to result in higher returns for your portfolio if the foreign securities perform better than the domestic securities.
What percentage of your portfolio should be allocated to foreign securities?
A study on the diversification benefits of international securities, conducted by Vanguard Advisors, found out that the maximum diversification benefit occurred when approximately 35% of a portfolio is allocated to foreign securities. There is no hard and fast rule on what the allocation to foreign securities should be because another study by Nationwide Financial noted that the allocation should be 40%. In spite of whichever study’s result you tend to be inclined to, the suggested percentage allocation by those studies may not be optimal for every portfolio, the optimal allocation to foreign securities should be dependent on the future performance of foreign securities relative to domestic securities.
Be Warned: Foreign securities come with added risks
Though the addition of foreign or international securities to your domestic portfolio results in a better-diversified portfolio with potential for higher returns, it also breeds additional risks. Firstly, the addition of international securities adds currency risk to your portfolio. However, depending on the relationship between the Naira and the currency on which the international securities are denominated, the exchange risk may be positive or negative. With a seemingly constantly depreciating Naira, the exchange risk is likely to add to the performance of your portfolio. Another risk to be mindful about in relation to cross-border diversification is a political risk.
So, in choosing which foreign securities to add, it will be reasonable to choose from countries that are politically stable. Yet another risk that adding international securities may present is that of inadequate information. You may not be able to know where to research the companies you wish to invest in, and such lack of familiarity to the foreign market information and data is a risk in itself. Securities laws differ across countries, especially in relation to taxation of capital gains. Addition of foreign securities implies that you should at least be aware of the basic securities laws in the country whose securities you want to add to your portfolio. That presents some challenges and risks.
The internet has made the world a global village, where you can buy and sell shares being traded in one country from another country. There are many online trading platforms worldwide that can facilitate cross-border diversification. In my next article, I will take a look at the major online platforms.