Most investors would agree that diversification is a good thing, but how many of us really understand what it means? All too often, South African investors think about global diversification as fleeing risk.
Diversification is about managing risk. It is not about avoiding or eliminating risk, which cannot be done without sacrificing investment goals. It also isn’t about trading one risk for another presumably lesser risk, nor should it be about taking risk indiscriminately for the sake of diversification. It is about making good investments but spreading them across different risks.
With this in mind, we address two misconceptions that many South Africans have about global diversification:
1. Moving your assets from South Africa to the UK is not global diversification
South Africa is an emerging market country with significant political and currency risks. The local stock market represents less than 1% of the global opportunity set. By now, most of us know this. This doesn’t make South Africa a bad place to invest, but it does make it a risky place to invest everything, which is what many local investors do.
For those South Africans who have decided to invest offshore, there often seems to be a significant bias towards the UK – possibly because the UK is familiar: Shared history, language overlap, similar time zones, etc. The idea is that the UK, a more developed market, has lower political and currency risk. Global diversification done.
There are two problems with this thinking. First, the UK only represents about 4% of the global opportunity set. Second, as Brexit has made it abundantly clear, the UK also has political and currency risks. The UK can still be a great place to invest, just not too much.
Have a look at two recent Business Insider headlines:
These articles demonstrate how any country, not just emerging markets, is subject to political and currency risk. Developed market risk may be lower than emerging market risk, but it is still there, and it needs to be managed.
A South Africa/UK portfolio might be better than South Africa-only, but this strategy remains vastly inferior when compared to true global diversification. The SA/UK portfolio still only represents 5% of the world, and 50% or more of your money will still be subject to the political and currency risks of just one country. Even worse, as recent events in both South Africa and the UK have demonstrated, the probability of simultaneous turmoil in any two countries remains uncomfortably high.
The answer also isn’t to move everything from the UK and concentrate it somewhere else, like Australia. This doesn’t solve the problem, it just moves it. Outside of the United States, no single country represents more than 10% of the global opportunity set, and even the Americans would do well to consider the rest of the world.
Global diversification means avoiding overconcentration to any country and taking advantage of the widest opportunity set possible: South Africa, UK, USA, Switzerland, Canada, Australia, Hong Kong, Japan, Europe, and so on.
2. The argument that “other places have their own risks” is not a valid case against diversification.
When making the case for global diversification, we’ve at times been countered that other countries have their own problems, and “fleeing” South Africa is just “swapping one devil for another”. This argument misses the point of diversification.
First, global diversification isn’t about fleeing one country for another, and in doing so exchanging one concentrated risk for another. This doesn’t manage risk, it just transfers it somewhere else.
Second, global diversification as a strategy doesn’t rely on finding places without risk. As the first point of this article suggests, no such place exists. Instead, it relies on spreading exposure between risks that are less than perfectly correlated.
To the extent that we can find two investments with similar merit that have different risks, it is better to hold both than just the one. Our risk of loss is lower because the probability of both risks playing out is lower than the probability of any single risk playing out. To the extent that we can find many good investments with different risks, it is better to hold many than just two.
Global diversification remains the best way to find many good investments with different risks.
This does not mean that indiscriminate diversification is a good strategy. Making inferior investments for the sake of diversification is a big mistake that will result in poor returns. Fortunately, having a wider opportunity set makes it easier to achieve diversification without sacrificing investment quality or returns.
In a nutshell, diversification is about exposing yourself to a wider opportunity set in order to find many good investment opportunities with uncorrelated risks. If you want to manage your risk properly, invest globally.