When it comes to investing, most of us like to stick to what we know doubly so when the economic climate is this uncertain. And on the surface, there are lots of good reasons for British investors to stick with the UK market rather than venture somewhere more exotic.
Firstly, British companies are familiar to us. Most of us know what Tesco does. We also assume we know a bit about its prospects, even if our knowledge is confined to what we glean from our weekly shop. Far fewer of us could claim to know much about China Resources Enterprise, the Hong Kong-listed Chinese retail conglomerate, even though it is in a similar business sector.
Second, there's the hassle factor. British shares are priced in sterling and pay dividends in sterling too. So there's no foreign-exchange conversion to worry about (although the fortunes of the company itself may well be exposed to currency fluctuations if it has overseas sales). Third, there's the broker problem. Once you start looking to buy exotic shares that are not listed in a big, liquid Western market, you may have to sign up with an overseas broker to do a deal that involves time, effort and cost.
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Why we should be more adventurous
So is it game set and match to domestic investing? Not at all. Diversification is important. Investors are often advised to stick to what they know, but this is easily misinterpreted it doesn't just mean investing in brand names you recognise. As the Psyfitec.com blog says, "competence in investing terms means understanding how a business makes money, not being an eager consumer of their services or products". Extrapolating from personal experience (of, say, your local Tesco) to making generalisations about the entire business is "a capital mistake".
Perhaps the most obvious example of this is people who pile huge chunks of their personal wealth into their own employer via share ownership schemes. It's tempting, because if you work for a firm, you might think you know it better than anyone else. But even if you regularly scour the financials, that's a very risky strategy. If you depend on one company's survival for your income, your pension and the future returns on your portfolio, then you are stuffed if that company runs into trouble. Many a WorldCom, Enron or Lehman Brothers employee could testify to that.
The illusion of familiarity can also make investors lazy. Rather than finding the best company to invest in, they find the nearest one. For example, in The Language of Lucre, University of North Carolina professors Joseph Engleberg and Christopher Parsons show that local newspapers (understandably) tend to report more on local firms, and that this in turn drives local investor preferences.
Worse, we also assume that firms we know will deliver better returns than those we don't. But not only is this a daft idea, it's also dangerous. If you only buy firms that are already very successful, the chances are you will always overpay. As Psyfitec puts it: "If you only invest in the next Big Thing after it's become the next Big Thing you've already missed a large part of the growth."
But what of the fact that in the recent downturn, everything has fallen together? Does international diversification really work? It's a reasonable point, but ignores the fact that, while in the short term crashes can drag all markets down together, over the long run economic performance tends to vary across countries. So having international exposure will protect you against the risk of having all your money riding on the fortunes of one country.
In a 2010 paper, International Diversification Works (Eventually), Cliff Asness, Roni Israelov and John M Liew at AQR Capital Management compared the performance of local' portfolios versus globally diversified ones across 22 countries, over the period from 1950 to 2008. They found that, for periods of longer than three and a half years, the impact of global crashes was no worse on diversified portfolios than on local ones. Over five years and longer, the worst-case scenarios for global funds were "significantly better" than for local portfolios. In other words, over the long term, being globally diversified "protects you quite well".
How to do it
Many British brokers offer access to a range of overseas markets. However, if you'd still rather stick with London listings, then the good news is that many of the UK's largest blue chips are heavily exposed to overseas markets. And don't forget exchange-traded funds (ETFs). These offer an easy and cheap way to add foreign markets to your portfolio, usually by tracking an index. Do check the fund fact sheet, however, as some ETFs (particularly in emerging markets) are heavily exposed to certain sectors, such as banks.
Cris Sholto Heaton regularly looks at good ways to get exposure to Asian markets, in particular in his free weekly email, MoneyWeek Asia. His favoured investment trusts just now include New India (LSE: NII), and Scottish Oriental Smaller Companies (LSE: SST).
This article was originally published in MoneyWeek magazine issue number 562 on 4 November 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
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