Research Paper on "Investment Portfolio Diversification"

Research Paper 4 pages (1507 words) Sources: 3

[EXCERPT] . . . .

Investment Portfolio Diversification

Over the last several decades the world economy has become more globalized. Part of the reason for this is: increased amounts of cooperation and an effort to reduce trade barriers as much as possible. This has had a dramatic impact upon the world of investing, as the markets have become increasingly interconnected in one way or another. For many investors, this has meant the opportunity to increase their overall returns. Like with any form of investing, some of the emerging economies that promise above average returns; could have a number of different factors that may increase the underlying risks. To mitigate these different effects, a strategy known as international portfolio diversification has been used. Simply put, this is when an investor is reducing the overall amounts of risk to: a particular region, country or asset classes; by diversifying their investments in a number of different areas. The idea is that by investing in a variety of asset classes and specific regions / countries, investors can be able to maximize their overall return, while reducing their risks as much as possible. ("International Diversification," 2010) What this shows, is that as globalization is changing the world, prudent investors are adapting to what is taking place, by changing the way they account for risks. To fully understand the overall scope of international portfolio diversification requires: examining three benefits of diversification and how three different international mutual funds have used this strategy. Together, these different elements will provide the greatest insights, as to how international diversification can reduce your risk, while maximizing the total percentage returns.

Three Benefits of International Portfolio Diversification

Like what was stated earlier, the biggest reason why investors are using international portfolio diversification is to reduce the overall risks that they could be exposed to. This has created a number of different unique benefits for investors that are utilizing this strategy the most notable would include: they are reducing the risk for a particular country / region / industry, they are creating multiple sources of income and they are able to adapt to changes in the economy better. When looking at the first benefit, it reduces the risks for a particular country / region / industry, it is clear that one of the biggest reasons why investors are using this strategy is: to reduce their exposure to particular country or region. What happens is specific factors could take place within a particular country / region that could have ripple effects on the markets. When investors are using international diversification they are reducing risks, by having investments in a number of different regions and industries. Those investments that have been performing well or are more income orientated; will provide stability to the portfolio against various risks that could be faced. ("International Diversification," 2010)

The second benefit of international diversification, it creates multiple sources of income, highlights how this can provide investors with added income while reducing their risks. When investors are evaluating the risks vs. rewards, they will often look at the total return. This is the total amount that is earned from an investment or the interest / dividends that are received (income). During the process of diversifying in different areas, most investors will more than likely select stocks that will pay higher amounts in dividends and assets classes (such as bonds), which will provide consistent income / stability. Once this takes place, is when the risks are reduced to the portfolio even more, as the income that is received from the dividends and interest will add to the total return. If one particular area begins to perform poorly, the income portion of the portfolio can help provide protection against these kinds of situations by providing consistent income, which can help to mitigate the decline in one area / asset class of the portfolio. (Blanchet, 2010)

The third benefit that international diversification provides to investors is: it allows them to adapt to changes that are occurring in economic conditions. When investors are using diversification they will have a wide variety of areas and investments. During those times of economic prosperity, is when the markets will become overbought, as various bubbles have been known to develop at these times. For the prudent investor, international portfolio diversification will allow them to take their profits when these kinds of situations occur. Where, the large increase in asset values will cause the portfolio to increase dramatically. It is at this time and during the beginning of changes in the economic cycle; that investors can take their profits and diversify. This will protect them against the changing economic conditions. (Blanchet, 2010)

Three International Mutual Funds that have Used this Strategy

Three different international mutual funds that have used this strategy to successfully invest would include: the Dodge and Cox International Stock Fund (symbol: DODFX); the Artito International Equity Fund (symbol: JETAX) and the T. Rowe Price International Equity Index (symbol: PIEQX). When looking at the Dodge and Cox International Stock Fund, it is clear that they are investing in non-U.S. based companies that have the potential for above average growth. With the portfolio currently holding shares in: Novartis, Vodaphone, Glaxo Smith Klein and Nokia. The fund has also invested in a variety of bond ranging from: U.S. Treasuries to junk bonds. ("Dodge and Cox International Stock Fund," 2010) as a result, the overall amounts of volatility are a little higher than the markets, with the fund showing a beta factor of 1.14. The beta factor is used to determine the volatility of the markets. ("Dodge and Cox International Stock Fund," 2010) a reading of 1.0 would indicate that the investment has the same volatility as the major market averages. Anything higher than 1.0, would indicate higher amounts of volatility. (McClure, 2010) in the case of DODFX, this show that given the increased amounts of risk of investing internationally, the overall amounts of volatility were reduced to almost match the same amount for the market averages.

The Artito International Equity Fund invests in a variety of non-U.S. based companies the largest holdings in the portfolio would include: Companhia Vale Do Rio Doce, Nestle and Samsung just to name a few. ("Artio International Equity," 2010) the variety of companies that fund invested into, has meant that it has a beta factor of .98. This signifies that shares are slightly less volatile than the market averages. ("Artio International Equity," 2010)

The T. Rowe Price International Equity Index invests in different common stocks of non-U.S. based companies. ("T. Rowe Price International Equity Index," 2010) a few of the largest holdings would include: Nestle, Total, Blount International and Telephonica. The fund has a beta factor of 1.02. This signifies that shares are just slightly more volatile than the averages. ("T. Rowe Price International Equity Index," 2010)

What all three mutual funds show, is that the overall risks can be reduced by international portfolio diversification. Evidence of this can be seen by looking at the beta factors of all three funds which ranges from: .98 to 1.14. This is important, because it shows how diversification is helping these funds to invest internationally and reduce the overall amounts of volatility, to the point where they mirror that of the equity markets. When you can reduce the volatility of an investment, this means that the underlying amounts of risks have decreased. This is because those investments that are more risky will see larger amounts of volatility, as the increased risks cause investors to become overly optimistic or pessimistic very quickly (which causes the volatility).

Clearly, international portfolio diversification can reduce risks dramatically. Where, it offers numerous benefits, three of the most notable would include: it reduces risks of investing in a particular region / country, it increases income and allows investors to adapt to changes in the economy. These factors… READ MORE

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