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Recent events prove why international diversification still has appeal

Diversifying a portfolio between different geographies seems to have taken on an even more important role than ever before.

Clearly, buying shares that operate in a range of regions across the globe has always been a means of lowering overall risk, since a slowdown in one part of the globe could theoretically be offset by strong growth elsewhere.

However, following the EU referendum, the US election, the Chinese growth slowdown and further political risks in Europe, owning shares that operate in a variety of regions could prove to be essential in order to generate high returns over the medium term.

European risk

The European economy has faced considerable uncertainty in the last year. In 2017, this has taken the shape of elections in France and the UK.

However, the main challenge facing the region is, and is likely to continue to be, Brexit. While the performance of the UK economy has been relatively impressive since the EU referendum in June 2016, higher inflation resulting from weaker sterling could now have a negative impact on consumer spending.

The result of this could be a downgrade to UK economic performance. Difficulties in the UK would be likely to spread throughout the EU, since the two are highly interdependent.

While both economies have ultra-loose monetary policies in place which could help to offset some of the difficulties the region faces, entering a ‘known unknown’ period post-March 2019 may mean investment and confidence in Europe declines.

Chinese slowdown

Attention seems to have shifted away from a Chinese ‘soft landing’ in recent months. The slowing of the growth rate of the world’s second-largest economy seems to have been surpassed in terms of risk by the events in Europe and the US.

However, in August 2015 and again in January 2016, stock markets responded negatively to news of a slowdown in China.

While government stimulus and the promise of consumer spending growth opportunities have reduced concerns somewhat, the potential for problems and challenges in China could hurt share prices in future.

Therefore, while Emerging Markets such as China have been a key growth area for international investors in the past, it may not be prudent to be overly exposed to the region in future.

US political challenges

While Donald Trump’s presidency has thus far been relatively positive for stock markets, the fact is that many of his policies have not yet been put in place. For example, his spending plans have yet to be implemented, while there will be an inevitable time lag before they begin to impact on the wider economy.

However, his plans to raise spending on areas such as defence and infrastructure could lead to a higher rate of inflation. Combined with lower taxes and a Federal Reserve which may be somewhat dovish due to concerns about choking off an economic recovery, this could lead to higher inflation and a degree of economic turbulence.

While the US may seem like a sound place to invest due to its potential growth rate and the rising share prices seen in the early part of 2017, risks remain to the performance of the world’s largest economy.

Currency opportunities

With sterling having weakened since the EU referendum, many investors have experienced first-hand the positive effects of currency translation. While this can work for an investor at times, there are also long periods of time when negative currency effects hurt earnings, valuations and investor sentiment towards a particular region.

Therefore, it can be prudent to have exposure not only to companies which have operations in a range of geographies, but also to a variety of companies which report in different currencies. That way, an investor may be able to negate the potentially damaging effects of currency translation in the long run.

This may mean that currency gains are somewhat neutralised, but since most investors focus on company fundamentals rather than foreign exchange fundamentals, this may provide their best opportunity to achieve index-beating returns over a prolonged period of time.

Looking ahead

Clearly, the major economies of the world face clear and identifiable risks which could jeopardise their economic performance. This fact has been thrust into the limelight in the last couple of years with Brexit and other European political risks, Donald Trump’s election victory and the continued slowdown in China’s GDP growth rate.

Therefore, it seems prudent for investors to have a mix of stocks which operate in different geographies within their portfolio. On the one hand, this may be seen as a means of reducing potential returns if a particular country or region performs exceptionally well.

However, on the other hand it could in fact be a method whereby an investor reduces country-specific risk in order to allow their focus on stock selection and company fundamentals to shine through.

While risk is omnipresent in investing, recent events have brought it sharply into focus. Diversifying may seem obvious and somewhat unexciting, but it could lead to an improved risk/reward ratio for Foolish investors in the long run.

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