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International Diversification A Tool To Hedge Against Portfolio Risk

Updated on August 7, 2014

International diversification


Investors are always searching for methods or techniques to reduce the risk of their portfolio, and increase their returns. One method that has become successful is diversification. Diversification is choosing many stocks from different industries and sectors to protect the investor from factors that influence each industry or sector. The theory behind the diversification is that industry or sector specific factors will affect each stock within that industry or sector. An investor who has stocks diversified among industry can reduce the risk of these factors. International diversification is the same theory by using investments from other countries and markets.

The United States went through a financial crisis and the stock markets in the United States plunged to low levels. The crisis affected all stocks in the American markets. An investor who had investments in different markets around the world would not have been affected as much because of the international diversification. International diversification provides benefits for investors because of risk/return trade-off, international markets offer more opportunity, and investors can take advantage of the rapid growth in emerging markets.


Hedging risk in the international markets


The risk/return tradeoff from international diversification is one of the most important benefits for implementing this strategy. The macroeconomic factors within a country can have a domino effect and influence each sector of business. The macroeconomic factors such as unemployment rates, interest-rates, inflation, policy changes, and increased taxes can cause negative effects on domestic businesses. An investor will want to hedge against the factors that could decrease the value of his or her portfolio. International diversification will provide the investor opportunities to hedge risk against domestic influences. Different business cycles exist in different regions of the world. An investor can have investments that include the various business cycles to generate returns in one area while the other area is decreasing.

Correlation is very important to the investor because negatively correlated stocks will move in opposite directions. If two stocks are negatively correlated then when one stock increases in value the other will decrease and vice versa. An investor who implements negative correlation in his or her portfolio will protect it from generating huge losses because as some assets are decreasing in value the other will be increasing. The diversification among assets should lead to less risk of the expected returns or higher expected returns for the same risk. Every investor should want to have higher return for the same level of risk he or she is currently taking.


Opportunities in the international market place


International markets offer the investors more opportunity because the much larger selection of investments. International markets will provide a hedge against domestic macroeconomic factors that will drive value down in the domestic market. The United States market holds less than 50% of the market capital in the world. An investor who chooses to invest in domestic securities is only using less than half of the opportunities available. International markets provide the investor with opportunity to generate gains through growth of international economies. Many economies are implementing infrastructure, national resources, and raw materials to grow their economies. The investor will create gains through investing in these markets. Globalization has made the world a smaller place and made many countries interdependent upon each other. The growing globalization has allowed different countries to implement new technology and efficiencies to produce their resources. Developing these resources at a lower cost has made these economies profitable. The investor will want to invest in growing economies, and customers who many domestic companies have not reach yet. The international markets allow investors to create opportunities that domestic markets do not offer.


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