Diversification In International Stocks: Expanding Your Global Investment Reach – Diversification is a risk management strategy that creates a diverse mix of investments in a portfolio. A diversified portfolio consists of a mix of different asset types and investment vehicles in an attempt to limit exposure to any one asset or risk.
The rationale behind this technique is that a portfolio constructed with a variety of assets will, on average, provide higher long-term returns and reduce the risk of any individual holding or security.
Diversification In International Stocks: Expanding Your Global Investment Reach
Studies and mathematical models show that holding a diversified portfolio of 25 to 30 stocks is the most cost-effective way to reduce risk. Investing in more securities provides more diversification benefits, but it does so at a greatly reduced efficiency rate.
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Diversification seeks to smooth out irregular risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification exist only if the securities in the portfolio are not perfectly correlated—that is, they respond to market influences in different, often opposite, ways.
As investors look for ways to diversify their holdings, there are dozens of strategies to implement. Several of the methods below can be combined to improve the level of diversification in a single portfolio.
Fund managers and investors often diversify their investments across asset classes and decide what percentage of the portfolio to allocate to each. Each asset class has different, unique risks and opportunities. Classes may include:
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The theory states that what adversely affects one asset class can benefit another. For example, rising interest rates generally have a negative impact on bond prices because yields must rise to make fixed income securities more attractive. On the other hand, an increase in interest rates may cause an increase in rent for real estate or an increase in commodity prices.
There are tremendous differences in the way different industries or sectors operate. As investors are diversified across different industries, they are less likely to be affected by sector-specific risks.
Consider, for example, the CHIPS and SCIENCE Act of 2022. The law affects many industries, but some companies are more affected than others. Semiconductor manufacturers are most likely to be affected, while the financial services sector may experience the least, residual impact.
The Benefits Of Portfolio Diversification
Investors can diversify across industries by pooling investments that can balance different businesses. For example, consider two major entertainment media: travel and digital streaming. Investors hoping to hedge against the risk of future major pandemic impacts may invest in digital streaming platforms (positively impacted by more shutdowns). At the same time, they may consider investing in airlines (positively affected by fewer closures). In theory, these two unrelated industries could reduce risk to overall records.
Find out there are too many variables to consider and “there are no better stocks that have a well-diversified portfolio.”
Public equities can be divided into two categories: growth stocks and value stocks. Growth stocks are stocks in companies that are expected to have higher profit or revenue growth than the industry average. Value stocks are shares of companies that appear to be trading at a discount based on the company’s current fundamentals.
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Growth stocks are more risky because the company’s expected growth may not materialize. For example, if the Federal Reserve tightens monetary policy, less capital is generally available (or borrowing becomes more expensive), creating a more difficult scenario for company growth. However, growth companies can tap into seemingly limitless potential and outperform expectations, delivering higher-than-expected returns.
Stock values, on the other hand, tend to be more stable, stable companies. Although these companies are already enjoying much of their potential, they typically have low risk. By diversifying into both, an investor capitalizes on the future potential of some companies while also identifying the current interests of others.
Investors may want to consider investing in different securities based on the underlying market capitalization of the asset or company. Consider the main operational differences between Apple and Newell Brands Inc. In July 2023, both companies were in the S&P 500, with Apple representing 7.6% of the index and Newell Brands representing 0.0065%.
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Every company has a different approach to raising capital, introducing new products to the market, brand recognition and growth potential. Low stocks have more room to grow, although high stocks are safe.
In almost every asset class, investors can choose a security’s underlying risk profile. For example, consider fixed income securities. An investor can choose to buy bonds from the world’s top governments or from nearly defunct private companies raising emergency funds. There are significant differences between the various 10-year bonds based on the company, their credit rating, future management outlook and existing debt levels.
The same can be said for other types of investments. Risky real estate development projects are more stressful than established operating properties. Meanwhile, cryptocurrencies with a longer history and greater adoption, such as Bitcoin, are less risky than smaller coins or market tokens.
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Diversification may not be the best strategy for investors looking to maximize their returns. Consider the “YOLO” (You Only Live Once) strategy, where 100% of capital is invested as a high-risk investment. While there is a high probability of making life-changing money, there is also a high probability of losing it due to poor diversification.
Unique to fixed income securities such as bonds, different term lengths affect risk profiles. In general, the longer the maturity, the greater the risk of fluctuations in the bond price due to changes in interest rates. Short-term bonds offer lower interest rates; However, they are less affected by uncertainty in future yield curves. Investors who are more comfortable with risk may consider adding long-term bonds that pay higher interest.
Length of maturity also prevails in other asset classes. Consider the difference between short-term lease agreements for residential properties (ie, up to one year) and long-term lease agreements for commercial properties (ie, sometimes five years or more). While there is greater security in collecting rental income when locked into a long-term contract, investors sacrifice flexibility to raise prices or change tenants.
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Investors can gain additional diversification benefits by investing in foreign securities. For example, the forces depressing the US economy may not affect the Japanese economy in the same way. Therefore, owning Japanese stocks gives an investor little cushion from losses during an American economic downturn.
Alternatively, there may be greater upside potential (and correspondingly higher levels of risk) when diversifying between developed and developing countries. Consider Pakistan’s current classification as a frontier market participant (recently downgraded from an emerging market participant). Investors willing to take on higher levels of risk may want to consider higher growth potential in smaller, less established markets such as Pakistan.
Financial instruments such as stocks and bonds are intangible investments; They cannot physically touch or feel. On the other hand, tangible investments such as land, real estate, agricultural land, precious metals or commodities are tangible and have real-world applications. These physical assets have different investment profiles because they are used, leased, developed or treated differently than intangible or digital assets.
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Tangible assets also have unique risks. Real property may be vandalized, physically stolen, damaged by natural conditions, or rendered obsolete. Real assets may also require escrow, insurance or security costs. Although income streams are different from financial instruments, entry costs are also different for protecting tangible assets.
Another aspect of diversification is how these assets are held, regardless of how the investor intends to construct their portfolio. Although this is not an implication of investment risk, it is an additional risk worth considering as a diversifier.
For example, consider a person with $400,000 in US currency. In all three situations below, the investor has a single asset allocation. However, the risk profiles differ:
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The same concept above applies to almost every asset class. For example, Celsius Network filed for bankruptcy in July 2022. Investors holding cryptocurrencies with the exchange faced an inability to withdraw or transfer funds. If investors are diversified across platforms, the risk of losses is spread across different exchanges.
Consider different strategies to offset technical risk and physical risk. For example, owning physical gold bars and gold ETFs can diversify your portfolio through different risks. If your physical assets are stolen, at least 100% of your gold ownership is not lost.
Time and budget constraints make it difficult for non-institutional investors—that is, individuals—to create a well-diversified portfolio. This challenge is one of the main reasons why mutual funds are so popular among retail investors. Buying shares in a mutual fund provides an inexpensive way to diversify an investment.
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While mutual funds offer diversification across different assets, exchange-traded funds (ETFs) allow investors access to narrower markets, such as commodities and international plays, that are typically difficult to access. A person with a $100,000 portfolio can spread the investment between ETFs without overlap.
There are several reasons why this is beneficial for investors. First, it is more expensive for retail investors to purchase securities using different markets
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