“Don’t Put All Your Eggs In One Basket” has brought the concept of diversification. Which has brought forward the term of an investment portfolio.
Diversification is a technique to pacify unsystematic risk by allocating investments across different asset classes, diverse industries, and cross border investments in the portfolio. The rationale behind this strategy is to yield higher long-term returns and lower the risk exposure of the portfolio, rather than concentrating funds in a single asset class, investors diversify their investments across a range of investment vehicles.
- To offset losses in one asset class with gains in another asset classes
- Reducing the volatility of the portfolio.
- Achieve higher expected returns.
- Balance both positive & negative external factors influencing the movement.
Types of Diversification Strategies
- Asset Diversification: The investor can invest in different types of assets such as Equity, Commodities, Fixed income, Real estate, etc.
- Diversification within a specific asset class: Allocating funds on the basis of various sectors, company size, market capitalizations, etc. For example, a mix of categories under the equity umbrella such as large, mid and small-cap stocks.
- Geographical Diversification: Investing across domestic borders. Investment across different markets in the world facilitates reduction of risk in the portfolio as the exposure is in various economies.
Benefits of Geographical Diversification
- The risk of recession in emerging countries can be offset by investment in developed countries like the US.
- A prudent investor in search of alpha can benefit from low international correlation and derive value from profitable opportunities.
- Currency Risk,
- Political Stability,
- Legal Aspects, and
- Taxation Policies
Challenges faced by market participants in geographical diversification
- Experiencing Home Bias: Home bias is a phenomenon where investors choose to invest the majority of their portfolio in domestic equities, thereby disregarding the advantages of diversifying their funds into foreign equities.
- Lesser knowledge: MyFinopedia is there to bridge the knowledge gap between the investors and the cross-border investment diversification strategies.
- Unaware about the need of Diversification: Diversifying the investment portfolio across a global peripheral helps the investors to compensate for the volatility of any economy.
An investor may have various cognizance for investing in the global markets such as the effects of the pandemic on the economies, valuations being sprawled, currency oscillations, taxation policies prevailing in the states etc. There are different unforeseen external factors which do affect a particular region and to offset the imbalance, it would be optimal to spread the portfolio to cover such heart breaks.
US Equity Market – A perfect destination
A profusion of opportunities are unwinding in the largest market of the world, the US market. Let’s study the impact of structural opportunities and robust performance of the US market.
- Revival: The US economy has started showing signs of post pandemic economic revival supported by the vaccination rollout, reducing number of cases, herd immunity, and increase in business activities. Government increased its spending and these initiatives will play an important role in strengthening employment levels.
- Innovation: The US market introduces innovations across various sectors. Further advancement is due to growth of innovative themes which helps to get an exposure which may not be available in domestic country.
- Strong fundamentals: The US economy has acceleration in demand, consumption, and investment acts backed by huge net worth. The GDP growth is expected to surpass pre-pandemic levels and allow more productivity growth with the low level of debt.
- Future potential: The investor can park funds for the long-term and benefit from the growth potential of the market. Reopening of the consumer service sector and technological advancement will surely enhance the growth of the economy.
Relevance of US market
- Indian markets correlation: Inclusion of US equities, an investor gets advantage of effective diversification as there is a low correlation between the US and the Indian economy. It will not only facilitate effective diversification but will also give an opportunity to benefit from the US economy growth.
- Exposure: USD is not only a key asset which is coined as a world reserve currency. The investor can make use of this to meet his future expenses with investments today.
- Risk diversification: The investor can diversify the portfolio by investing in the US market which is the widest stock market in the world. This carves the path for effective diversification and risk adjusted exposure.
- Better performance: The US markets have witnessed a consistent equity market with low volatility over the last decade & driven by higher earnings growth. Hence, it’s a wise decision to invest in US equities for the long-term. In January 2021, the stock markets in the United States accounted for nearly 56% of world stocks.
Diversification can aid the investor to attain the financial goals, reduce the risk of the portfolio, and achieve higher expected returns. The importance of diversification is highlighted in terms of tapping the growth potential of the overseas market, which can be on the road to recovery post the pandemic. The demand of the consumers is showing a rapid upward trend due to opening up of the markets. Thus, an investor can take overseas exposure and benefit from effective diversification of the portfolio, low correlation with Indian markets, exposure to currency, and consistent market performance.