How a Diversified Portfolio Can Mitigate Risk

Often times when I review a prospective client’s portfolio it’s heavily tilted toward U.S. equities and contains little to no internationally based stocks. 

Many of us will readily admit to having a hometown bias when it comes to our favorite sports teams; however, we may be unaware that these same biases carry over to our own investment philosophy. 

The reality is, many investors are selling themselves short by not fully utilizing the global equities market, often resulting in higher risk portfolios with lower returns. In fact since 1970; international stocks from developed regions have outperformed the U.S. stock market about half of the time.

The most common example of these “hometown” biases is in portfolios that are heavily invested in U.S. based, multinational corporations such as Apple, Exxon Mobil, or Coca-Cola. 

While it’s human nature for people to avoid things that are unfamiliar to them and take comfort in what they know, this can lead to a false sense of security. The brand recognition of these conglomerates, along with their international presence, leads investors into thinking that they don’t need to diversify their portfolios with any international stock. 

In truth, while they are gaining some international exposure, it is very limited and lacks exposure to major asset classes such as small-cap and emerging markets.

Academic research has shown that investors have better outcomes when their portfolios are diversified among different asset classes because each responds differently to various market cycles and events. Although international funds are historically more volatile than similar domestic funds, adding international funds to a portfolio can provide greater diversification while potentially lowering the volatility of the entire portfolio. 

By seeking investments that are not highly correlated with one another you are increasing the potential for gains in one part of your portfolio to offset losses in another part. In other words, a well balanced portfolio with international exposure can help to reduce large swings and keep you cruising in the center lane of performance.

Diversification aside, international markets offer growth opportunities that the United States simply cannot compete with. International economies, benefiting from less mature markets, attractive demographics, and availability of natural resources are growing at higher rates than developed-market economies. 

In the last 15 years international emerging market stocks have outperformed the S&P 500 10 times. In fact, over that same period the Morgan Stanley Capital International Index has been the top performing major asset class seven times, with an average return of nearly 13 percent. This is not to say that international stocks are not without risk, but an investor without any international exposure over that time period would have missed out on a tremendous opportunity to grow their portfolio.

Most of us are unaware that the United States accounts for just over half of the global equity market. However, if recent trends continue the international equity markets will gain the majority of the market share before long. So before you purchase your next stock or equity fund, remember that investing internationally can help to diversify your portfolio, mitigate risk, and maybe even increase your return. (littleton)