I am sure you have heard of the word diversification before. Generally, the word is used to refer to the following:
- Diversification across asset classes – like equities, debt, real estate, gold, etc.
- Diversification within asset class – like choosing funds of different types (large cap, mid cap, small cap, multi cap or sectoral funds) within equity mutual fund portfolio.
- In case of a stock portfolio, it’s about holding stocks across sectors, industries, market caps, growth/value/dividend frontiers, etc.
But there is another kind of diversification that we often ignore – Geographical diversification.
As investors, we have a bias for our own country. And it’s natural. A significantly high percentage (if not 100% in majority cases) of our investments are linked to our own economy.
So that’s a big bet that we are taking. And in taking this bet, we are exposing ourselves to geographical risks.
A Simple Example of Geographical Risk
Think of it like this.
You are an investor who has learnt his lesson in diversification. You have multiple baskets of different assets (equity, debt, real estate, gold, etc.).
Each basket has eggs of its own.
Equity Basket has stocks, equity MFs, ETFs. Debt Basket has PPF, liquid funds, FDs. Gold Basket has physical gold, gold funds, gold ETFs.
So with different baskets, you have achieved diversification across and within assets.
But all these baskets are kept on one table. What if this table breaks down? All the baskets on the table will fall and eggs will be broken.
This is the geographical risk.
This risk is real but we don’t encounter it in our daily lives. We have other real life problems to take care off.
Even when we are aware of this risk, there can be reasons why we are only investing in what-is-familiar-to-us (i.e. within the country). Or as this article tells, the reasons might be:
- Lack of time / ability to do research
- Fear of consequences of currency fluctuations
- Complex procedures to carry out cross-border transactions
Now I know what you are thinking.
India is Long Term Growth Story. So Why Invest Elsewhere?
All this discussion about geographical risks is fine. But India is where growth is. The domestic consumption driven growth story is still intact. Even with reasonable assumptions, it is expected to last a couple of decades if not more. There are hardly other countries that offer such opportunities for investors. And this is the reason why foreign investors too have been buying here for years.
So our firm belief in the domestic growth story is a strong reason for not bothering about investing abroad. Other way to put it is that the opportunity cost of not investing in India is way too high given the expected growth in country’s economy.
But to be technically correct here, we need to accept that investing solely in one country opens up to a big risk (like the basket on table example).
In a way, it’s akin to investing in a sectoral mutual fund. The sector is expected to do well. But having all your money in it is risky. This is not a perfect analogy but you get the idea here.
Also, in spite of all the optimism about everything being in favor of our markets for next few decades, the risk of something-or-the-other going wrong are real. There can be events that can derail the economy for years. There can also be events that are ‘almost’ impossible to occur (black swan events).
So going for some degree of geographical diversification helps mitigate this risk to an extent.
Investing internationally is not much about seeking higher returns elsewhere as it’s about providing diversification (geographical one) to your existing portfolio.
Remember that Indian markets will not be the best performing market every year.
There have been and will be years when Indian markets (along with emerging markets) are beaten by more mature markets of developed countries. Also global markets don’t move in tandem or at least do not move together in the same degree many times.
So having some international exposure helps you diversify your portfolio and shield against poor performance of Indian companies, markets or the Rupee. It also opens you to additional opportunities that might not be present in home economy.
Here is what Jonathan Clements had to say about this (though in context of US markets):
I don’t know whether that will help or hurt returns. But it will reduce risk – and potentially save you from financial disaster.
Simple Maths behind Currency Risk in International Investments
Let’s take a small hypothetical example to understand a new type of applicable to overseas investments.
Don’t worry – the maths is fairly simple.
Suppose that a year ago, you invest in shares of a company listed in USA @ $100 per share. After one year, the price of share is $120.
So the return for an American Investor is 20%.
i.e. 20% = ($120 – $100) / $100
But since you are in India, your returns will depend on the exchange rate between INR and US$ at the time of purchase and sale (assuming you sell).
Talking of exchange rates, it’s worth mentioning that Fintech revolution is playing out here too like it is in personal investing. Earlier, established banks had clear monopoly in international money transfers. But now, money transfer companies offer charge transfer fees that are several times less than what banks charge. This drastically brings down overhead costs (check rate comparison sites) when money is to be transferred for investing abroad by sophisticated investors.
But ignoring taxes, transaction costs, etc. for simplicity here, there are two possibilities.
The exchange rate can either go up or down. Returns will be different in both cases.
The returns are as follows:
- 8% if INR depreciates (assuming from $1=Rs 55 to $1=Rs 65)
- 5% if INR appreciates (assuming from $1=Rs 65 to $1=Rs 55)
As you can see, the difference in returns for Indian investors is huge. US investor is saved as he is investing in his local currency ($). His return is clear 20% without any risk from currency fluctuations. The returns for Indian investor on other hand depends on the $-INR Exchange Rate too.
Here is the full calculation:
This is what currency risk is. Investments made overseas are exposed to currency risk, especially if the currency of the country being invested in depreciates in value against the home currency.
What to Do?
So how much international exposure should your portfolio have?
Sorry – I don’t have one clear-cut answer here.
But answer depends on who you are.
If you are young to middle aged and have a small portfolio, you are better off focusing on other important things – like getting your personal finances in order, investing regularly for chosen financial goals. You won’t get much benefit out of increasing your portfolio’s international exposure. Now purists might not agree with me but I feel that small investors should not worry much about geographical diversification.
The case for large and sophisticated investors is different. They are not just bothered about returns but also about controlling the downside of their large portfolios. This can be achieved to an extent by investing a small percentage in overseas markets that generally move in direction different to our markets.
So if your portfolio already has good, well-diversified and proven domestic equity funds, then having an international equity exposure would be a good addition.
When Indian markets are not performing well due to local factors, international funds can deliver returns that will compensate for poor performance of Indian investments.
However, I think that investors should have a cap of about 10% or max 15% for overseas investments.
That is because I am personally bullish on the long-term India growth story. In spite of the volatility expected here due to various known and unknown factors, I believe there is enough money to be made in the country.
And even though global funds might give better returns in few years, the average returns over long term will be higher for good domestic funds.
But nevertheless, if the portfolio size is large, it is a fairly good idea to take a small exposure in global equities as part of the diversification process.
Thank you very much for the post. I have been wondering about it for long time. With the LRS scheme it is possible for Resident Indians to own foreign stocks. Can you please comment if you get a chance:-
On Valuations and Fundamentals: In my observation the balance sheets, income statements and cash flow statements of US companies are bit different than the Indian companies, right ? The accounting standards they follow is not the same. In some cases goodwill and intangible-asset valuations can be challenging task. Secondly, the internet sources which are available for free do not give a 10 year record. 4 year records are easy to get. Lastly, though there are plenty of US companies, they usually have a disadvantageous financial ratios compared to Indian companies. (debt-equity the worst hit because of cheap credit). Even though EPS is moving slow, the stock prices are moving in an irrational manner.
On Taxation aspects: If one is holding Indian stocks for more than 1 year, the gains may be tax exempt u/s 10(38). For a resident holding US company stocks, one has to file W8-BEN time to time (I think once in 3 years) and when you sell it is subject to long term CG taxation in one of the countries. (In short, 20-30% will be chipped off..). So From Indian Taxation perspective (for a resident) a foreign stock which he buys has to give a ‘really outstanding’ return to match with an Indian stock giving a mediocre return to achieve the same return. Am I right in this taxation angle?
Country macro economy perspective: After the 2008 debacle, the consumption patterns in US has changed. Inspite of keeping interest rates so low, the economy seems to be slow. Yellen finding it a hard decision to increase the rates. I am not sure of the QE story. The US debt mountain and derivative bubble* is hanging heavy on the US markets. In India the (domestic) consumption pattern + growth of middle-class, rise of smart cities is showcasing a much positive sign.
It is a tough qn to answer, But do you feel the $ will get stronger against INR in long term? (There is nothing to support it – other than, countries like China, IMF, India holding dollars and also the world accepting it as international currency, but for how long?)
* Article: These are scary articles before we invest anything in world markets. Is it true?
I had quite a few questions on related topic of diversification (though, not necessarily globally) – e.g.,
1. how to invest in stocks listed globally, say, in UK or US or Brazil ? (and/or currency)
2. how to invest in private companies (again, domestic or globally – another diversification – far more risky, though) ?
3. how to invest in bitcoins ?
Had been browsing on above-mentioned in bits-and-pieces – still going through learning curve. Thought of mentioning here, since the topic deals with diversification.
Hi dev I’ve started investing in market since last 1-1.5 years and I’m still learning about the market will it be safe for me to invest in other countries at this point?
Assuming your portfolio size is not very large, please first focus on investing in Indian markets. And do so with one eye on your financial goals. Geographical diversification can happen later.
Nice article Dev. Here are my two cents.
One is understanding of foreign companies, their growth opportunities is tough for retail investor since he doesn’t have access to real life situations there. Investors who cannot fully understand the risk reward ratios while investing in home country will be playing with an additional handicap while investing abroad.
Second is currency risk that you’ve highlighted is real and and can have significant impact on the portfolio returns. India being an inflationary economy and having structural chances of remaining the same over next decade or so the currency is destined to steadily depreciate against deflationary economy countries apart from few tactical years where it’ll be otherwise due to short term factors. This in my belief adds a larger risk to the portfolio than the benefit one could get by diversifying abroad. And if the reason one wanted to invest into global markets to reduce risk it’s beaten by adding more of currency risk.
Alternative way to look at it is like this. When would growing economy like India have bad stock market results over longer term? Only when there is no growth, bad politics, geopolitical risks, low corporate profitability, high inflation. All of these situations will also mean that Indian currency would have simultaneously depreciated at the same time. So if an investor has invested in India and abroad at the same time his portfolio will suffer on both sides causing risk to accentuate than reduce.
In my humble opinion a small retail investor is better off staying put in a long term structural story where he understands the nuances better than elsewhere where the chances of outsized gains are low and multiple additional risks get added which he’ll not be able to mitigate since he can’t hedge against those risks effectively.
You have captured most of the points.
I do strongly agree that for an average investor with limited resources, it is better to stick to focus on domestic investments that includes all equity and debt investments. However, for someone, whose portfolio is large (meeting all local financial needs) and requires real diversification and not just focusing on higher returns, overseas mutual funds is an good option (again not individual stocks).
Apart from diversification, the investment decision also depends on the individual market valuation and valuation in comparison with other markets. I myself have invested in European Funds and China Funds from the point of diversification and also based on relatively cheap market valuation compared to other stock markets like US and India.
There are many drawbacks in investing in overseas funds like high fund management charges, currency risk, geo-political risk of particular country and not to forget the taxation part (as the capital gain from this investment are treated same as Debt investment capital gains).
Whenever the Indian Stock market is giving you higher returns those overseas fund returns will look very meager and mostly investor will regret it as waste of time / opportunity, but it may be worth investing overseas when the valuation is attractive. Currently European and Chinese market are cheap in comparison with US and Indian Markets and therefore I allocated some surplus money from the point of diversification and attractive valuation (I could be wrong also).
Another class of overseas fund that I had invested (and still invested) is World Gold Funds. These funds are very volatile but entry and exit at right time gave me good returns. I don’t suggest this category of fund for all because it’s volatility.
Hey Dev, thanks for explaining diversification in such detail I’ll definitely think of it when my portfolio is large enough.
Hi Dev, I am planning out to invest in mutual funds where I can get the tax benefit so can you help me out with this?
Can you send me a mail with details?
I am investing on market based plan since 10 years India. i am planning to invest internationally, and doing research. this article helped me. Thank you for sharing..
Thanks Sukanya 🙂