Geographical Diversification: Expanding Your Horizons For Financial Security
Diversification, in general, is the practice of spreading investments to a variety of options to mitigate risk. It’s the equivalent of not putting all your eggs in one basket.
Geographical diversification involves holding securities from different regions. Avoiding concentration in a single country or region helps manage risk, similar to how you wouldn’t want to place all your money in one stock. The failure of that stock can severely impact your portfolio.
Businesses also utilize this strategy by operating in multiple regions or countries, thereby decreasing business and operational risks.
Key Takeaways
- Geographical diversification minimizes portfolio risk by avoiding excessive concentration in one market.
- It can include investments in developing countries with higher growth potential than developed economies.
- However, risks like unfavorable currency fluctuations and political instabilities do exist.
Understanding Geographical Diversification
Like diversification in general, geographical diversification is based on the idea that financial markets in various global regions may not be highly correlated. For instance, if U.S. and European stock markets are suffering due to a recession, an investor might allocate part of their portfolio to high-growth emerging economies like China and India.
Large multinational corporations also exhibit a high degree of geographic diversification. This permits them to reduce costs by situating plants in low-cost regions, while lowering currency volatility impacts on their financial statements. Revenue growth from high-growth regions can help balance slower-growth regions.
Pros and Cons of Geographical Diversification
Advantages
- Reduced Risk: Spreading investments across different regions can help manage the volatility of a single economic region, thereby reducing overall portfolio risk.
- Greater Growth Potential: Investing in developing markets can be more lucrative because they often provide higher growth prospects than saturated, competitive developed markets.
Challenges
- Global Interconnection: The increasing interconnection of the global economy may lessen the diversification benefit once enjoyed. Many large companies in developed markets already operate globally.
- Elevated Risks in Fast-Growing Economies: Emerging markets may pose heightened political, currency, and general market risks compared to developed economies.
- Currency Risk: Exchange rates are volatile, and unfavorable movements can erode investment returns. An investment in Japan, for example, can depreciate in dollar terms if the yen weakens, but investing in multiple currencies can reduce this risk.
Related Terms: portfolio diversification, emerging markets, multinational corporations, exchange traded funds, currency risk, political risk, mutual funds.
