Diversification Can’t Completely Eliminate Risk Exposure

Diversifying your investments means buying stock in several different companies. In an ideal world, if one of those companies did poorly, then the others would help mitigate your losses. But even this strategy can’t eliminate systematic risk (which comes from the fact that any given nation’s market constantly jumps around in different directions).

For instance, if you were to buy up all the same stocks that are in the S&P 500 (that would be stocks from 500 different companies), then the value of your portfolio would increase and decrease exactly the same as the overall S&P 500. Even though you diversified your portfolio, you’re still vulnerable to systematic risk.

For this reason, some investors look to other nations to mitigate risk. After all, many times when one nation’s markets are crashing, another nation’s economy is booming. For example, if you owned stock in only U.S. companies at the end of 2007, you would’ve lost quite a bit because the value of pretty much all U.S. stock crashed.

If, on the other hand, you held stock investments in China, as well, the amount of your portfolio’s total value that was lost wouldn’t have been nearly as big because China’s equities didn’t crash in 2007 like most of the Western world.

However, investing internationally has its own inherent risks not otherwise found in traditional equity investing. Here are just a few of them:

  • Foreign exchange risk: Foreign equities are denominated in the currency of their nation, so even if the value of your equity stays the same, if the exchange rate drops, your investment is worth less to you.

  • Foreign regulations: These regulations may restrict you from taking your money out of the country.

  • Political instability: The government may fall apart altogether after a rebel coupe. (A lot of U.S. investments in Cuba were seized and lost during the Cuban Revolution.) Or a nation in which you have investments may have culturally engrained nepotism or corruption within executive management that results in poor competitiveness.

As with any investment or serious business venture, when you’re diversifying your investments internationally, you absolutely must do your research on the risks and maintain due diligence so that you continue to stay knowledgeable of any changes. But even though you can mitigate quite a bit of systematic risk by diversifying internationally, you take on a degree of unsystematic global risk at the same time. It’s a trade-off.

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