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.
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 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.