Don’t confuse a global portfolio with a well-diversified one. Learn the difference.
Is it time to forget about global diversification as a portfolio strategy? Or put another way, is it time for investors to ask themselves what they’re trying to accomplish by diversifying their portfolios with international investments?
Because the U.S. has such a broad reach through economies across the globe—as the buyer/seller/maker of goods and services—you might not really be “diversifying” your portfolio by layering in stocks from, say, China, Korea, or Europe. Instead, it might make sense to spread your risk in other ways.
“The problem with global diversification is that the U.S. has relationships, meaningful relationships on many levels, across the globe,” says Harrison Napper, product manager at TD Ameritrade. “And diversification doesn’t know the boundaries of countries."
“The flow of money doesn’t know when or where to go. It just goes,” he adds. “And the U.S. plays a fairly key role in that global economy.”
As a result, your globally diversified portfolio may not be all that “global” at all. If the U.S. economy tanks—like it did in 2008, for instance—much of the rest of the world might tank, too.
The reverse can be true as well. When there are problems in Europe or Asia, there’s generally a reverberation across the globe. When Britain voted to exit the European Union last summer, markets everywhere were placed on high alert. Fast-forward a year, and all is mostly well among the world’s major economies.
“For the first time in many years, we are seeing signs of synchronized economic expansions at home and abroad, and the balance of risks globally has become more positive,” Federal Reserve governor Lael Brainard said in a speech in May.
Typically, investors seek out global stocks and bonds as a means of reducing exposure to the U.S. But that might not work too well when the countries they’re investing in are closely tied to the U.S. So does this mean investors might be better off hedging a U.S.-centric portfolio rather than trying to diversify globally?
“We have to separate the concept of diversification from the concepts of risk and hedge,” Napper says. “If you’re trying to hedge a risk, hedge that risk. There are other alternatives that can help do that.”
For instance, he adds, an options trader who's afraid of the possibility of a general market downturn might consider buying put options on the S&P 500 Index (SPX). With such options, you pay a premium for the right, but not the obligation, to sell the underlying index at a specific price (the "strike price"), on or before a specific date (the "expiration date"). But if it’s out-of-the-money (OTM) at expiration, you lose the premium plus transaction costs that you paid for the option. For more on the basics of put and call options, please refer to this recent primer.
Diversification is an attempt to avoid putting all your investment eggs in one basket. As Napper says, investing in candy companies all over the world over won’t minimize losses if everyone stops buying candy.
“Stocks are expensive, and they don’t have return policies like some of the goods we buy,” he says. “So investors should consider being cautious about overinvesting, and surgical in their worst-case strategies so they don’t spend 50% of their upside potential to hedge a 1% probability event.”
“A global portfolio can certainly be global,” he adds, “but that shouldn’t be taken to mean that I’m more protected because I own stocks in different countries.”
Asset allocation and diversification do not eliminate the risk of experiencing investment losses.