The Basics
Many people only invest in the UK. In fact, statistics from the Investment Management Association (IMA) show that around 60% of the money in UK equity funds has been invested in UK stocks.
The main motivation for investing overseas is not to enhance returns but to try to reduce the risk of your portfolio. Whether it is by shares, sectors or geographically, diversification lowers risk. If some stocks, sectors or stock markets perform badly, this can be offset by others delivering positive returns at the same time.
Diversifying internationally can provide access to economies and stock markets that are growing faster than the UK. Overseas markets will have greater exposure to certain sectors than the UK. Dividend yield is also rising outside the UK.
For all these reasons, if you are only invested in the UK, you may increase the risk in your portfolio and miss out on higher growth and income in overseas markets.
The degree to which international markets move in the same direction at the same time is known as correlation. The lower the correlation between two markets then the greater the diversification benefits.
The Benefits of Diversification
You can benefit from different levels of sector exposure in various markets. For example, while technology comprises around 20% of the US stock market, it only accounts for 1% of the UK market. Investing overseas enables you to access sectors, such as oil services, that have little if any presence in the UK. It also allows you to invest in well-known global companies like Microsoft and Samsung that are not listed in the UK.
Furthermore, the different sector weightings also provide the opportunity for short-term tactical changes in asset allocation. Generally, when global risk appetite rises, the UK will under-perform other countries, notably those with a higher proportion of growth stocks, such as emerging markets. Despite the rise in correlation between markets, economic cycles still present opportunities even if they are over the short term, such as through investment trusts.
To enhance diversification, you should not only spread your risk across equity markets and sectors but also asset classes. Holding asset classes such as bonds, property and alternative investments should further reduce volatility across your portfolio. Research indicates, for example, that there is negative correlation between US equities and bonds when there is deflation or fears of deflation. Many managers predict low correlation between equities and bonds while inflation remains relatively low.