As the 2018 FIFA football World Cup heads to a thrilling climax it has reminded me of the importance of having a globally diversified investment portfolio. Not surprisingly, as in football or any other sport, investors tend to be very home biased by usually holding the majority of their investments in stocks which are based in their home country. This is often not the most optimum strategy and I will go over my reasoning for this here.
Key financial independence principles
Having financial independence requires that you own a collection of assets which are capable of providing you with passive income which is more than your expenses. Once you reach this stage working for money becomes optional as you will be free to do what you want with your time. Using principles explored on this site and others it can take a relatively long time (typically 8 to 15 years) to achieve this therefore it is paramount that the most optimum strategies are applied. The key principles include:
- Spend less than you earn and invest the rest
- Maintain a very high savings rate
- Invest in low cost stock market index funds
- Diversify your portfolio
- Keep investing costs very low
- Avoid trying to time the market
The power of diversification
The principle I am focusing on is portfolio diversification. A common way to diversify is by constructing a portfolio composed of stocks and bonds. Bonds should only be included to reduce volatility and protect a portfolio’s value from market downturns for the short term. As a young person striving for financial independence I reduced my bond allocation to almost zero in-order to maximise investment returns. The few bonds I hold are within micro portfolios which may be deployed in the near future for short term goals such as buying a car or property.
As a UK based investor only 20% of my portfolio is made up of UK stocks. The rest consists of international holdings (approx. USA 35%, Europe 20%, Japan 15%, Pacific excluding Japan 10%). This proportion is roughly in line with the weightings of global GDPs (Gross Domestic Product) of these developed economic areas. GDP is a measure of the total value of goods and services produced by the region.
With a global portfolio influenced by the above statistics, you can ensure that to a large degree you will benefit from any growth within these regions.
Currency risk – is it worth it
It is important to note that by investing outside you home country you will gain exposure to currency risk. If your currency gains relative to other currencies the portfolio will reduce accordingly and if your home currency loses value then your portfolio will increase in value. I experienced this personally in 2016 when my portfolio jumped by +20% after a drop in the pound sterling.
This is a double edged sword so you should try to get a balance by not overexposing yourself to one region. However, I believe that in the long run currencies in stable economies generally revert to a certain valuation and have low volatility. The benefits of diversification and our inability to predict the future outweigh this risk in my opinion.
Another side of the argument is that for investors in major economies such as the US or UK there is no need to invest internationally as the companies in the major indices (S&P 500 and FTSE 100) already do a lot of their business overseas. This is entirely true but it is not a guarantee that these investments will keep on performing as well as in the past. An interesting article on this is on Morningstar.
Like in this year’s football world cup, expected results are often far from the reality, with all the big teams (Spain, Argentina, Portugal, Brazil, Germany) crashing out unexpectedly. We simply don’t now where the next big gains will come from. It is best to globally diversify, tune out the noise and keep investing.
You might also like:
- The true cost of home bias and currency risk on investments
- Earn Passive Income by using Index Funds
- Top 5 portfolio holdings – USA Index Fund
- Top 5 Portfolio Holdings – UK Index Fund