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Reduce risk by investing in foreign shares

World trade is an ancient business, with markets bringing East and West together for centuries.

Sensible investors put their money to work across the world, rather than only investing it at home.

Buy British or Made in USA are good slogans for the sellers of knitwear, tractors, and cauliflowers, but they’re a poor guide if you want to build a robust portfolio.

This isn’t because I expect the British stock market to whither away like our coal mining or ship building industries did, or because the troubled UK economy is doomed.

On the contrary, I think the London Stock Exchange is one of the world’s most attractive, with companies that offer an appealing mix of growth, income, stability, and innovation.

As for the UK economy, reports of its death are much exaggerated.

Besides, the biggest UK companies that dominate the FTSE All-Share index do over 75% of their business overseas. This means they’re far less dependent on the performance of Blighty PLC than is popularly supposed.

But our companies are more exposed to certain regions of the world than others.

It’s been said, for example, that we export more to Ireland than we do to the BRIC1 nations combined, which is a tad worrying given how it sometimes seems there are more Irish backpackers in Irish bars across the world than there are Irish citizens in Ireland!

More generally, UK trade is dominated by business done with mainland Europe.

But trade is a global affair nowadays.

Investing overseas therefore gives you access to different types of companies and opportunities, unconstrained by history or the geographic accident of our lump of rock’s position on the spinning globe.

Gambling with your country’s money

Investing in foreign shares exposes you to currency risk, which is to say your overseas investments will change in value as their price in the local currency fluctuates when converted back into pound sterling.

In the short-term this can be a good or bad thing, in terms of your profit – it depends how exchange rates go after you make your overseas investment.

Over the long-term, however, currency variations on average play a minor role in total equity returns. Currency hedging is expensive and difficult for private investors, so I wouldn’t worry too much about it provided you’ve got a long time horizon and you’re spreading your equity buying across the world.

Oh, and in case you’re wondering if overseas investing means you’ll need to phone city boys in Shanghai or Sydney to place trades, fear not!

While you can hold even individual foreign company shares in an ISA, the majority of us are best off using collective funds for the money we invest away from our home country.

(Most of us are best off in UK trackers, too, for that matter, but that’s a different dozen or so articles).

Investing overseas via funds could entail you buying index trackers that follow foreign markets, like those we use in our Slow & Steady model portfolio. You can even track emerging markets using passive funds.

Alternatively, new country-specific ETFs are debuting all the time, though most investors will find it simpler and safer to aim for broader regional exposure.

Some investors like myself also put money into big global investment trusts like RIT Capital Partners. This trust invests very widely around the world, and its managers actively monitor currency exposure as an added benefit (or not, as it may turn out) for its shareholders.

Investing globally is more helpful with shares than bonds

The main benefit of investing overseas is that diversification across countries can be expected to reduce risk in your portfolio, without doing too much damage to your overall return.

According to the latest research from the very credible London Business School2, the risk reduction you’d have seen from holding the world index rather than owning only domestic equities between 1972 and 2011 made diversification worthwhile for every major country studied except South Africa.

They found that investors in the core 19 countries looked at3 would have enjoyed a risk reduction of on average 20% from holding the world index, as opposed to if they’d held only their own countries’ shares.

Academically speaking, that’s a trade-off you should take, even if it slightly reduces your return (though see below for more comments on risk).

Investors from Norway and Finland would have seen around a 50% reduction in risk, due to how skewed their economies are, and the overweight presence of a few massively larger companies. Take note, if you’re Norwegian or Finnish!

Interestingly, the professors do not report the same risk-reducing benefits from diversifying into global bonds.

With bonds, the currency risk outweighs the benefits of diversification.

This is probably because in general, a creditworthy government bond is a creditworthy government bond – it pays you a fixed rate of interest and you (hopefully) get your money back when the bond matures.

Hence currency risk looms large with bonds, compared to the minor diversification benefits of holding one developed country’s bond versus another, given that most mature developed world sovereigns have not defaulted in the past few decades. (Some might suggest the professors stand ready to re-write their rule books.)

In contrast to bonds, by buying foreign shares, you are getting access to different country’s industries, trading partners, local specialisms and resources, as well as varied politics and demographics.

That’s real diversification!

The risks of picking the best countries to invest in

Some foreign share markets will likely do a lot better than others in our lifetime, of course.

This means spreading money across the world’s stock markets will likely reduce your returns, compared to if you bought only the best performing markets.

But before you put on your red braces and go winner-spotting, keep in mind:

  • Investing in fewer overseas markets will lower the risk-reducing benefits you’ll enjoy, compared to investing in the global index.
  • Most people are likely to be as bad at picking winning markets as they are at picking winning stocks, so they will lose to a global tracker (or else they’ll simply pay for any higher returns by taking more risk – see below).
  • If a market grows faster or looks cheaper, it may be for a good reason (likely because it will be more risky and/or volatile).
  • You’re more likely to stomach the most volatile but potentially highest reward markets – e.g. Brazil or Russia – if their gyrations are offset by steadier holdings elsewhere in your portfolio.

Remember, risk isn’t necessarily something to be entirely shunned. I haven’t got a problem with a young investor putting a bigger allocation into a spread of emerging markets, say, for the prospect of higher long-term returns, provided they’ve understood the extra volatility that’s likely along the way.

But I would still argue against betting very heavily on any particular country, or even region, in the pursuit of extra riches.

Few of us really want to gamble away a happy retirement for the prospect of a few more bottles of champagne in our old age.

Accordingly, most of us should sacrifice a few tenths of a percent of return by spreading our money more widely in order to sleep better at night. It’s the same rationale as that for having a diversified portfolio that includes bonds and other low return, low volatility asset classes.

As we’ll see in my next post, you don’t want to try to pick the United States of the 21st Century, only to discover you actually invested in the equivalent of the Greeks.

  1. Brazil, Russia, India and China. []
  2. The Credit Suisse Global Investment Returns Yearbook 2012, to be exact. []
  3. Basically all the biggies where they have data stretching back to 1900. []

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{ 19 comments… add one }
  • 1 gadgetmind February 16, 2012, 7:38 pm

    Slightly off topic, but you mentioned RIT, so …

    They’ve had a bad period lately: when the markets go down, RIT goes down, when the markets go up, RIT goes down!

    As they were on a slight discount, and as I still like their diversity, I recently picked up a chunk in my SIPP, but I hesitated long and hard.

  • 2 Ben February 16, 2012, 8:00 pm

    As of today my SIPP and ISA has downsized from a grand total of 13 (unlucky for some) to a measly single index fund, the HL effect finally having kicked in.

    Hopefully all my diversity will be taken care of ‘behind the scenes’ by Vanguard.

    That said I already have an II account waiting in the wings to take over where HL left off…

  • 3 westy22 February 16, 2012, 9:05 pm

    @Ben
    I’ve done pretty much the same – down from 7 HSBC index trackers to 1 Vanguard LifeStrategy 80% Equity fund in my HL SIPP before the 29 February which is when they would have started charging me £14 per month for the privilege.

  • 4 gadgetmind February 16, 2012, 9:13 pm

    I tore up my HL SIPP paperwork and went with BestInvest instead. OK, so it’s £120pa, but that covers Vanguard trackers, ETFs, equities, etc.

    And they just gave me £500 for moving, which they beamed into my fund account, only for me to forward to my bank account with the next stage being Oddbins.

  • 5 The Investor February 16, 2012, 9:23 pm

    I understand the motivation and frustration with HL, but as I’ve said many times before I’d personally never put all my money in one fund, or even hold it all with one platform or provider.

    When first starting out it’d be okay. But forget about a £2 monthly fee, you couldn’t pay me to hold *all* my money in one place now.

    No slight meant towards Vanguard, which seems to be about the perfect operator from a private investor’s perspective.

    I’ve just seen too many things go wrong over the years to not be somewhat paranoid, personally.

    Which — to bring us back on topic — is another good reason to invest overseas. In the long term I’ll probably look to hold some assets offshore, too. All above board and declared if required, but just as another string.

  • 6 ermine February 17, 2012, 12:42 am

    > hold some assets offshore, too

    are we moving towards a Permanent Portfolio angle 😉 tinfoil hat optional and all that…

    The Greek denouement could hold interesting times for us to live through!

  • 7 AnAdmirer February 17, 2012, 9:25 am

    I’m in the same boat as Ben.

    Paranoia around fund/platform diversification is a good thing but it can go too far if you’re not careful. There is a trade off in terms of the extra admin/cost in rebalancing and managing multiple funds as well. There’s no panacea but I can certainly understand as your pot grows bigger, so does your fear of losing it.

    The main problem with Vanguard is that there’s no-one else quite like them, particularly for the “one-shot” LifeStrategy funds i.e. globally diversified, fixed bond/equity split, trackers and very low cost. Some other funds come close in some areas but fall down in others (mainly costs) – any counterexamples would be very greatly appreciated!

  • 8 Rob February 17, 2012, 10:27 am

    Really it comes down to one a key trade-off between how much of that diversification you want against how easy it is / how happy you are investing money in a foreign countries assets… China for example may be one where the risks might outweigh the benefits.

    Chatting with someone who has a reasonably large portfolio we talked this through in some detail and we came to the opinion that is was worth doing… it just isn’t worth the risk of having it all based on one country where any currency devaluation could be problematic. We came to the conclusion that its best to try and spread a good portion across countries that we admire the culture of… it knocked an awful lot of countries and even whole continents out of the equation (Japan for example with its different loyalty structure), but what’s left is sufficient.

    The only problem is that the one we most admired was Germany… a great approach to saving money and then reinvesting it in high end businesses that are highly innovative… I’m sure you can find the flaw in that idea though… at least for now. That said, we did think it would be good to have some exposure to Asia and North America, as well as Europe when the Euro zone can be sorted out satisfactorily.

  • 9 The Investor February 17, 2012, 11:30 am

    @Rob — Yes, I think individual investors can to an extent try to judge risk and reward for certain outliers, if it helps them sleep at night. I think you could take China out of the mix and still get most of the risk reducing benefits (but possibly lose some return – or possibly not. Nobody knows, as you know! 🙂 ) I don’t think you could take ‘Asia Pacific’ out without skewing your return.

    Of course, as ever an active approach that picks winners is better *if it proves correct*. That’s the rub!

    I remember growing up in the late 1970s and early 1980s in sclerotic Britain, every day hearing about how Japan was the country of the future, how I would have to wear a blue jumpsuit to work for company wake-up sessions every morning, how my future would be designing robots for Japanese factories etc. I am sure the ‘no brainer’ of investing in booming Japan played a big role in pushing its asset bubble to the absurd lengths it reached.

    Even ten years ago people were writing off Germany. Now everyone admires them. These things go in cycles, and most are crowd-followers, not thoughtful contrarians.

    @AnAdmirer — Fair enough, it’s a personal decision really. Once above say a pot of £50,000, I think it’s a false economy to save £50 on TERs by not say running your SIPP with HL/Vanguard, but maybe investing the UK allocation into a HSBC index tracking ISA. We are dealing with tail risks, but these things only look apparent in retrospect. People who invested in Equitable Life, for example, thought they were doing the safest thing possible. We can all go Google why they were wrong and be wise after the event, but it wasn’t clear at the time, or even on the radar.

    I can’t imagine how Vanguard could blow up, but I don’t think it’s impossible. Some far-fetched examples might be fraud, some sort of US asset freeze/repatriation, false accounting, improper checks and balances or insurances as it cuts costs to keep its TER down, moneys not properly segregated between account owners, computer error…

    Do I think any of those are even remotely likely? No. Do I think they’re possible? Stranger things have happened. Perhaps the biggest practical risk is you simply can’t get access to your money for 6-8 weeks, but even sitting around locked out of your life savings with no Plan B isn’t a scenario I want to be exposed to.

    As I say, nothing against Vanguard at all. I’ve been pointing friends to the LifeStrategy funds.

    Pays your money, takes your choice! I know I’m in a minority on this, I think even The Accumulator is all in on platforms, if not on funds.

    @ermine — Hah, lucky I know you know me well enough. No tin hat paranoia here, just the health skepticism that all free-market supporting capitalists should approach any financial transaction with IMHO.

    Right, off to bury some cans of spam and baked beans under the rose bushes.

  • 10 OldPro February 17, 2012, 2:19 pm

    Templeton Emerging Markets Trust results hit the doormats this week… Mr Mark Mobius who has been at it a long time presently has big bets on China (well via HK), Brazil and I was surprised by this one Thailand…Bargain hunting after the floodwaters perhaps?

  • 11 Rob February 17, 2012, 2:39 pm

    @ TheInvestor – “Even ten years ago people were writing off Germany. Now everyone admires them. These things go in cycles, and most are crowd-followers, not thoughtful contrarians.” – I think to think of countries through the old people on an island argument. The countries that spend or are unproductive do worse. A look into Japanese culture makes it a place where you potentially run a higher risk of fraud, merely because the loyalty is to the individuals not the company so you have to be more careful. The whole set up in Germany makes it easier for innovation to succeed and that is a wonderful quality in a country.

    Funnily enough the Japanese bubble would have never happened had banks tied lending more closer to realistic valuations (especially borrowing against land) and had people not believed that land and property being a finite resource could justify excessive valuations… remind you of anything?

    As with stocks you either be better than average or you spread the risk and do it passively…

  • 12 Niklas Smith February 17, 2012, 3:31 pm

    A very interesting post, especially because you put some numbers on the benefits of international diversification in shares. That said, I have been skimming the Credit Suisse Yearbook and I can’t find these percentages that you mention – could you give a page reference? (I did see that the professors say: “The risk reduction achieved through global diversification remains one of the last ‘free lunches’ available to
    investors.”, page 57.)

    Since ermine mentioned the Permanent Portfolio, it’s interesting in this context that Harry Browne and his current acolytes generally argue that the shares allocation should be invested only in domestic shares, as the 25% gold allocation provides enough currency risk/exposure.

  • 13 The Investor February 17, 2012, 4:44 pm

    @Niklas — Hmm, does it not? I was drawing it from a hard copy presentation that I believe the LBS professors made available coincident with the Yearbook launch (slide 20, if you can get hold of it — unfortunately I don’t have a link to a download) which I presumed was all cited from the Yearbook, since it references it repeatedly. I haven’t read every page of the Yearbook yet, though I have extracted out some interesting numbers for a follow-up post next week. Perhaps the data they are citing is contained in the Sourcebook (the Yearbook’s bigger brother). Or perhaps it’s in neither! Anyway, I assure you it’s bona fide from them. 😉

    @Gadgetmind — Missed your comment about RIT. I have a smaller holding than in the old days when it was on a glorious 14% discount (I reduced my holding as the discount turned to a premium) but I still carry some. It’s not a share that keeps me awake at night, that’s for sure! I don’t really recognise your characterisation, to be honest — as far as I can see it beat the FTSE 100 by a useful few % in 2011, though it is lagging in 2012. That’s not really a surprise, though, given it holds fixed income etc as well as shares. It seems to be on a premium still, too, though the private equity component is as ever a bit uncertain (though I’d guess conservatively carried). Give us a shout next time you see a big discount (10%+) as I’d probably like to buy more myself! The only emergent risk I see is the age of Jacob Rothschild.

  • 14 The Accumulator February 19, 2012, 12:54 pm

    @ Gadgetmind – nearly choked on my lunch laughing at your Oddbins strategy.

    @ Ben – sounds like you’re gonna miss some of that complexity?

    @ AnAdmirer – The HSBC World Index Portfolio range would appear to be an alternative to Vanguard LifeStrategy. It’s more expensive and I haven’t checked it out properly yet, but could be worth a goosey.

    @ The Investor – I’m diversified across platforms. I’m with you. When you calculate the long-term differential of the Best Option against the Second-Best, the difference isn’t awful. I’d rather guard against disaster in that instance.

  • 15 Weatherboy February 20, 2012, 12:50 pm

    Nice article, but like so many others writing about portfolio allocation from a UK perspective, there is absolutely no mention of corporate bonds. [to all brits:] There are bonds out there apart from gilts, you know! You’re arguing that you should buying some foreign shares but that buying foreign sovereign bonds is not worth the currency risk. But if you want a ‘total market portfolio’ then surely it will include some corporate bonds. So it would be interesting to know, from your perspective, whether any or how much of this should be invested abroad. Does the diversification benefit outweigh currency risk in the case of corporate bonds?

  • 16 The Investor February 20, 2012, 1:03 pm

    @Weatherboy — I don’t really like corporate bonds as an asset class, and think in most circumstances you’re better with a mix of equities and sovereigns. This isn’t a mainstream view perhaps but I’m not alone — e.g. David Swensen of Yale thinks similar. Generally I think corporates are harder to value/analyse than equities, and the extra yield (minimal over government bonds in normal times, albeit not now in these abnormally low-yielding AAA sovereign bond times) isn’t worth the extra risk, as you don’t get the downside protection / anti-correlation you get with government bonds.

    I’ve written about them in some depth when I last thought they were potentially good value (late 2008/early 2009):

    http://monevator.com/series/investing-in-corporate-bonds/

  • 17 The Investor February 20, 2012, 1:04 pm

    p.s. No problem with someone adding them to a passive portfolio at all!

  • 18 gadgetmind February 20, 2012, 1:39 pm

    I have some corporate bonds in my passive portfolio. I went heavy on equities, but am running 10% bonds, 15% property and infrastructure, 5% other and 8% cash alongside. The bonds are split as 30% in an active strategic bond fund, 35% in SLXX and 35% in ISXF.

    I’d much rather had gilt ETFs instead of those corporate bonds, but can’t bring myself to buy them at current yields. I’ll review this decision every six months until sanity prevails again, both mine and the market’s.

  • 19 Ben February 20, 2012, 2:13 pm

    @ TI & TA
    don’t panic, I’m not all in on HL and Vanguard – my interests are more diverse than a rothschild’s suffering from a bout of paranoia

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