Portfolio diversification is one of the most important tenets of personal finance. It is a risk-mitigation strategy that implies â€˜spreading investments across various financial instruments, industries & markets. While investing in a mix of different assets is common, diversifying investment across different countries can also be considered an effective strategy. When the portfolio consists of securities of domestic and foreign markets, it is called international/ geographical diversification.
Today, with a gradual decline in fixed barriers such as cross-border capital flows, information gathering & political controls; attaining international diversification in oneâ€™s portfolio has become even more accessible and vital.
Why is international diversification important?
Stock markets and economies of different countries tend to perform differently at the same time. In other words, the same global or local event is likely to affect two different economies differently. International diversification enables you to build a portfolio that can withstand firmly during economic crises and generate optimal risk-adjusted returns. For instance, letâ€™s assume you have invested in both Indian and US stocks. Now, if the Indian stock market takes a sharp downturn, you will incur partial losses as the investment in US securities can cushion your portfolio returns. This is because the US stocks will not be as much affected by the Indian stock market correction.
How to avail international diversification?
Â· Direct Equity
Foreign financial markets may have different characteristics than domestic markets. One can invest in the listed stocks of foreign markets through registered brokers. Investing directly takes a lot of research and analysis of the cross-border markets and requires paying higher charges. Other countries may not have the same rules or disclosure policies applicable to the companies, so it’s difficult to find out information about the company. Thus, investing directly in foreign stocks might be a tedious task for investors.
The maximum amount an individual can invest in international stocks through direct equities in one financial year is capped at USD2,50,000.
Â· Mutual Funds
International mutual funds in the form of Fund of funds or ETFs are the most cost-effective, easy, and convenient way to avail international diversification in your portfolio. After thorough research and deep analysis, the fund manager and the fund house build a scheme portfolio that lowers the chance of picking up the wrong stocks. Also, mutual funds are a less expensive investment avenue than a direct investment in foreign stocks.
Thereâ€™s no cap on investing in an international Fund of Funds (FoF). Investors can invest as much amount as they want in a year through these mutual fund schemes and get exposure to international companies.
Benefits of international diversification
Â· Exposure to international markets
International diversification gives access to markets with different characteristics and growth opportunities. Some of the leading global brands are from the US and other western countries. Investing in them by buying their stocks can help you grow and participate in their growth journey.
Â· Domestic market risk mitigation
International diversification can also minimize the concentration risk of investing in one region. When you invest in stocks across borders, you are likely to benefit from the various areas doing relatively better than your home country.
Â· Long-term wealth creation
When you invest in emerging markets (China, Brazil, India, etc.) that have more growth opportunities than the developed economies (US, Europe), your portfolio returns are likely to enhance over the years. Similarly, investing in developed markets like the US also presents a wealth creation opportunity as these markets are mature and relatively stable than the emerging markets.
Â· Protection from rupee depreciation
Since international diversification also implies diversification across currency, your investment portfolio strengthens against currency depreciation risk. For example, the value of the rupee has dropped from Rs. 43.435 on Jan 03, 2000, to Rs. 75.116 on Dec 03, 2021, against the US dollar. In such a case, having exposure to foreign currency through international funds can set off the impact of rupee depreciation.
Although one must consider risks associated with an international investment such as political/country risks, currency risk, legal and regulatory risks & settlement risk/trading costs before taking the final call. Investing in international markets can play a role in risk-mitigation of the investment portfolio, and therefore investors can allocate around 10% of their equity portfolio in international stocks or funds.