International Diversification: A world of opportunity
By Shadforth Financial Group
Portfolio diversification is one of the most fundamental and important tenets of modern portfolio theory.
In the context of global investing and under some very basic assumptions, diversification implies that a portfolio of global equity markets should produce a risk adjusted return superior to that of any single country. Yet foregoing what is often called the only free lunch available in investing, most investors continue to hold portfolios that are heavily weighted toward domestic securities: the famous 'home bias'.
Australian investors are particularly predisposed to 'home bias', where well over half of all investor equity holdings are in Australian stocks, despite Australia being only 3% of the global equity market.
Global diversification has been the subject of much debate over the years. Given the recent market downturn, critics of global diversification suggest that because global markets tend to become more correlated during crises, diversification is actually weakest when investors need it most. More simply, the distressing observation is that markets tend to crash at the same time.
While this reality impairs the ability of a globally diversified portfolio to protect investors from short, systemic crashes it does not diminish the overall value of global diversification. Those who dismiss diversification on the basis of this argument miss a world of opportunity. Investors whose planning horizon is longer than several months or a few years should not be overly anxious about the risk of common, short-term crashes. Instead, they should care more about long, drawn-out bear markets, which can be a lot more damaging to their wealth.
Over the short term, global diversification can indeed disappoint and seemingly let investors down exactly when they need it most. Not surprisingly, critics have claimed that international diversification offers little protection when compared with purely domestic portfolios.
We believe that this argument does not take into account medium and longer term thinking. While short-term crashes can be painful, long-term returns are far more important to wealth creation, accumulation and preservation.