What it means
The logic rests on correlation, which is simply a measure of how closely two things move together. Two economies that rise and fall in step give you very little protection, while economies driven by different industries, currencies and interest rate cycles tend to take turns having bad years.
For an investor the payoff shows up as less bounce for the same expected return. If a domestic portfolio typically swings 18% in a year and an overseas one swings 22%, a blend of the two can swing less than either of them, provided they do not move in lockstep.
For an operating business the same idea applies to revenue rather than share prices. A consultancy earning everything from one city's property market is exposed to that city's planning rules, its banks and its local recession; the same firm working across five regions can lose one and still survive.
The protection is real but it is not free. Foreign holdings bring currency risk, unfamiliar accounting, withholding tax and political risk, and for an operating business, running across borders adds cost and management attention that a single market never demanded.
There is also a limit worth recognising. Correlations between major markets have risen as capital has moved more freely, and in a severe global sell-off almost everything falls at once, so geographical spread softens ordinary bad years far better than it softens a crisis.
In practice
Real-world examples.
Example
A pension fund holding only domestic shares moves 35% of its equity allocation into developed overseas markets and 10% into emerging markets. Over the next five years its home market has two weak years, but the fund's overall equity return stays positive in four of the five because the overseas holdings offset the weakness.
Example
A specialist food exporter sells 80% of its output into one neighbouring country. When that country imposes new import checks, revenue drops by a third in a quarter, so the firm spends two years building distributors in six additional markets until no single country exceeds 30% of sales.
Example
A commercial property investor owns eight office blocks in one financial district. After a wave of tenant departures pushes local vacancy to 20%, the investor sells three buildings and reinvests in logistics warehouses in three different regions, accepting a slightly lower yield in exchange for less exposure to one local employment market.
Formula
Calculation
Portfolio expected return = (weight 1 x return 1) + (weight 2 x return 2)
Portfolio variance = (w1 squared x s1 squared) + (w2 squared x s2 squared) + (2 x w1 x w2 x correlation x s1 x s2)
An investor puts 60% of a $500,000 portfolio into a domestic market expected to return 8% with a standard deviation (a standard measure of how much returns bounce around) of 18%, and 40% into an overseas market expected to return 11% with a standard deviation of 22%. The correlation between the two markets is 0.4.
Expected return = (0.6 x 8%) + (0.4 x 11%) = 4.8% + 4.4% = 9.2%, which is $46,000 on $500,000.
Variance = (0.36 x 0.0324) + (0.16 x 0.0484) + (2 x 0.6 x 0.4 x 0.4 x 0.18 x 0.22) = 0.011664 + 0.007744 + 0.0076032 = 0.0270112.
The square root of 0.0270112 is 0.1644, so the portfolio standard deviation is 16.4%. That is below the 19.6% you would get by simply averaging the two risk figures (0.6 x 18% + 0.4 x 22% = 10.8% + 8.8% = 19.6%), and it is below the 18% of the domestic market on its own. The blend earns more than the domestic market and bounces around less than either market held alone.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Harrowgate Instruments, an invented maker of laboratory equipment, earned 92% of its revenue from a single country and treated that concentration as a strength because it kept logistics simple and the sales team small. Revenue had grown steadily for six years, and the board saw no reason to complicate a business that was working.
In the fictional seventh year that country entered a sharp recession, research budgets were frozen, and Harrowgate's orders fell 28% in nine months. Because almost all revenue came from one place, the whole company felt the drop at once, and a business with $40,000,000 of sales lost roughly $11,200,000 of them.
The recovery plan was geographical rather than clever. Over three years the invented company appointed distributors in eleven countries and set an internal rule that no single market could exceed 25% of revenue. Two of the new markets later had recessions of their own, but by then each accounted for less than a fifth of sales, so a bad year in one region cost the group a few percentage points of growth rather than a quarter of its turnover.
Watch out
Common mistakes.
- Assuming that owning shares in a domestic company with big overseas operations is the same as owning overseas assets, when the share price often still tracks the home market closely.
- Counting the number of countries rather than the correlation between them, so a portfolio spread across five economies that all depend on the same commodity looks diversified but is not.
- Ignoring currency, since an overseas holding can rise 10% in local terms and still lose money once it is converted back into your own currency.
Questions
People also ask.
Does geographical diversification lower expected returns?
Not necessarily, because the point is to reduce the swing in outcomes for a given return, though investors who move into safer foreign markets purely for comfort often do accept a lower return.
How many markets are enough?
Most of the benefit for an investor arrives within the first handful of genuinely different economies, and beyond that each extra market adds cost and complexity for a shrinking gain.
Should a small business diversify geographically?
Usually only after it is strong in one market, because spreading a thin sales effort across many countries commonly produces weak positions everywhere rather than safety.
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