This Is Why International Diversification Is So Important

November 27, 2017

This Is Why International Diversification Is So Important

  • The 30% international revenue exposure the S&P 500 offers isn’t enough.
  • It’s possible to add significant returns and lower your risk when investing internationally.
  • A look at economic health and fundamentals will show where it’s best to invest now.



Introduction

An often overlooked part of investing and portfolio strategies are currencies.

The easiest way to look at it is to say that it all evens out over time and that the only thing important is to be diversified. By owning the S&P 500 or companies that have global revenues, we could say that a portfolio is well diversified.

Figure 1: S&P 500 domestic and foreign revenues. Source: FACTSET.

However, as a mindless investing attitude certainly isn’t what I am known for, I’ll share with you my research on what the best and worst currencies to be positioned in are for the next 10 years.

The point of currency portfolio allocation is to find the better returns at the same risk or equal returns with lower risks. As much of the S&P 500 international revenue exposure comes from Europe, investors should be careful when assuming they are well diversified.

What Impacts The Strength Of A Currency In The Long Term?

The main factors that impact the value of a currency in the long term are relative supply and demand in relation to another currency, economic performance, current inflation and inflation outlook, differences in interest rates, capital flows, and sentiment. As for the short term, that’s a completely different ballgame and those who know how to trade currencies in the short term don’t need additional capital nor anything else, so be careful with forex trading marketing schemes.

Now, to find the strength of the biggest economies, inflation, and what will impact those economies in the next 10 years, we would have to have at least a thousand researches and huge economic mind power. Therefore, the cheapest solution is to use the research from Bridgewater, Ray Dalio’s hedge fund, where their economic research is made public to stimulate better monetary and economic policy decisions for the future.

According to Ray Dalio, the big shifts in economic growth are about two-thirds driven by productivity and one-third driven by indebtedness where the luck of having significant resources and avoiding conflict also helps. By using 81 economic indicators, Dalio has come up with a table that shows the expected growth of the world’s top 20 economies.

Figure 2: Dalio’s expectation of future economic growth per country. Source: Bridgewater.



You can read more about Dalio’s work in our article about economic success. Today let’s keep the focus on currencies.

Out of the first 9 most promising countries in the next decade, 5 are in Asia if we say Russia is in Asia, and 3 are in Latin America. Then we have the UK, US, and Australia, followed by European countries, Japan, and Canada.

If you are a long term investor, the above figure is the most important regarding international portfolio diversification and long term returns.

If you live in Europe, you should be heavily exposed to foreign investments. A similar situation holds for Canada and Japan while the UK, Australia, and the US should have significant exposure to Latin America and especially Asia.

The next factors that impact currency values are inflation and interest rates.

Figure 3: Interest rates, inflation, and 5-year expected inflation. Sources: IMF, USDA, OECD.

It’s interesting how the countries in the top of Dalio’s economic chart have interest rates above the inflation rate while the countries in the bottom have the opposite.

A quick look at the above table tells us that India, China, and Mexico offer the most long term stability.

How Should You Invest?

In the short term, anything can happen as it’s more related to sentiment and the market is extremely short term oriented. Nevertheless, when thinking about long term international diversification, one should really think about the above and at least have exposure to the environment. Emerging markets have a positive interest rate to inflation differential of around 2% which creates interesting investing opportunities and keeps their markets healthy.

That health, coming from economic growth, is exactly why exposure to emerging market is essential to any long term investor. Additionally, the dividend yield in some of these emerging market is excellent, even when measured in U.S. dollars.



This doesn’t mean that any investment in emerging markets is a good one. It’s always important to look for healthy future growth at a fair, or where possible, cheap price. By taking a look at the global fundamental table, we can see that the cheapest emerging markets that offer long term growth potential are China and Brazil.

Figure 4: Global fundamentals per country. Source: StarCapital.

India might sound like an attractive investment but it’s one the most expensive global markets, even more expensive than the U.S. market.

If you find a company in China or Brazil that has real assets to protect it from potential inflation, a stable business model, and a good yield, I would really think about taking advantage of the extremely expensive U.S. market to buy into cheap global markets.

Of course, no one can know what will happen in the short term, but let’s say Brazil becomes even cheaper, the practical thing to do would be to average down as the yield would be higher and the future potential returns as well.

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