How to construct a global investment portfolio

Most of us feel more comfortable investing close to home, says Martin Spring in the On Target newsletter. But there are great opportunities out there for those who are willing to expand their horizons. Here are the basics of putting together a successful international portfolio - and some of the mistakes to avoid...

As I'm currently travelling in Asia and Africa, so am a little out of touch with current global investment trends, I've decided to write to you this month on the subject of basic moneycraft

Investing internationally is becoming more popular with individuals as we acquire a more global perspective from travel, business media, the internet, the migration of family members, and the growing importance in our lives of foreign businesses such as Toyota, McDonalds and Samsung.

Nevertheless, most of us continue to keep our savings invested close to home. We feel more comfortable with our knowledge of locally-registered investments. It's so much easier to deal through someone you know. And any investing abroad involves the additional unknown of valuing in currencies other than your own.

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Wealthy people, in a better position to know about these things, are becoming more internationally-minded in their investment, especially if they live in places that offer limited opportunities or are sensitive to political and similar local risks.

A recent Capgemini/Merrill Lynch study reported that in a single year wealthy North Americans (those with financial assets of $1 million or more) doubled their foreign holdings. Admittedly, that was from a small base. But wealthy investors living in Asia have more than half their assets offshore, while those in Europe have "sizeable" investments abroad.

Despite globalization, even now there are few investment advisers, anywhere, with a truly global perspective. It's only human to be biased towards the markets with which we're most familiar.

Finding useful information on the internet on specific investments is a hit-and-miss business, especially once you stray outside the US and the UK.

Very little has been been published in the way of general planning advice for individuals who want to invest globally since I gave up the editorship of the Johannesburg-based newsletter International Personal Finance several years ago.

As in the case of domestic investing, the international variety requires a carefully-planned strategy if it's to be successful - that is, offer attractive returns at acceptable risk. And it needs sensible periodic maintenance which needn't necessarily take a great deal of your time.

Here are the essential elements of sound international investment planning, as I see it

Your global plan: Work out an asset allocation plan, selecting suitable funds, shares and other assets for each sector and region of the world that is appropriate for your financial situation, personal objectives and risk tolerance.

Build a simple spreadsheet on your personal computer, assigning a percentage to each sector or region and showing the percentage of each existing holding in your plan.

Use indexes as the benchmarks for measuring performance. My first choice for equities is the MSCI index as I can use it to judge the performance of my global portfolio as a whole, rather than its individual components. Other benchmarks are useful for measuring the relative returns of particular assets, such as gold prices as the basis for comparing gold shares and funds.

Make sure you keep proper records of your transactions, as the tax collectors could come back and bite you years down the line. Save all order confirmation and period statements of your holdings.

Global diversification is important: Reducing risk by spreading it is a basic investment concept that applies just as much to an international as to a domestic portfolio, except that in this case it means you need to invest in a dozen or more countries rather than a dozen or so companies.

Studies have shown that a well-diversified global equity portfolio is only one-tenth as risky as a typical single share and, for an American investor, only half as risky as a well-diversified portfolio holding the same number of purely US stocks. Over the long term, it's also likely to give a better return.

No single stock market is immune to a shakeout; you reduce risk by spreading your money. Smaller markets, in particular, tend to be out of sync. 'Regardless of what happens to the world in general, there is always a bull market somewhere,' says the Amsterdam-based commentator Paul Melton.

A study by Bruno Solnik published in the Financial Analysts Journal showed that diversifying across countries generally brings you better investment results than diversifying across industries.

That's because a share's price correlates more with the market in which it is listed than with the industry in which the company operates. Swiss stock-market trends, for instance, largely determine the price of Nestl shares, even though more than 95 per cent of Nestl's cash flow is earned abroad.

How to diversify: We all know that it's sensible to have some American, some European and some Asian equities in a global equity portfolio, but buying a handful of shares or funds on the basis of media reports or broker recommendations is a haphazard and inefficient way of going about it.

It's important to have balance in your international investments. To achieve that, you need a plan and a disciplined process to monitor and change your holdings when necessary.

A simple approach would seem to be just to buy units in a global tracker fund, but that is neither as simple as it sounds - nor even the best way to achieve a proper balance.

If you take this route you accept the bias towards very big companies, which are the ones that dominate the indexes. But such businesses are not usually the most dynamic. Nor do they even survive, in the long run. At the end of the 20th century the benchmark index of America's 30 largest firms retained only one that was in the index at the start of the century (General Electric).

Another problem with indexes is "survivorship bias." As the performance of companies deteriorates, they drop out of the indexes, so the indexes give an exaggeratedly favourable picture of the reality.

The usual way of achieving global balance is through buying in predetermined proportions a basket of individual stocks, regional or country funds, or index-based derivatives or exchange traded funds.

But there is a lot of disagreement over how you should set those proportions.

One common approach is to base them on relative market capitalization. But this builds the wrong kind of bias into your portfolio. You bet most heavily on those markets that have grown the most strongly, and are therefore most likely to be overvalued.

Weighting a portfolio for all the major markets outside the US - Europe, the Far East and Australia - would have meant having 70 per cent of your non-US assets in Japan in 1989, just before its bourse plunged into a severe bear market.

Another widely-used approach is to use set proportions.

Melton has advocated this approach, but the breakdown he favoured is highly controversial, giving relatively heavy weightings to minor markets such as New Zealand and Norway. He claims that an international portfolio of shares or fund units with this kind of bias towards minor and emerging markets is, judging by history, guaranteed to outperform one based on a market-cap-weighted global index.

I have a more conservative view, especially for a long-term portfolio requiring little attention - one-third in North America, one-third in Europe including the UK, and one-third in Japan and the rest of the Asia-Pacific region. That's only an approximation, of course. I'd be happy to invest in a particular Latin American share or country if I judged there to be a good reason for doing so.

Managing your portfolio: Once you've built your portfolio, you need to keep an eye on it, and make occasional changes.

Very occasional. Resist the temptation to tinker endlessly, second-guessing yourself. Switch off the TV business programmes full of perpetual optimists promoting their own interests, and refuse to be sucked into reacting to the latest predictions of interest rate changes or market corrections. Your time would be better spent on improving your knowledge of long-term trends and how markets work.

Not more than once a quarter, but not less than once a year, evaluate your progress. See how close is your asset allocation to the targets set in your plan, and how you're performing relative to your chosen benchmarks.

If they're not performing well, there may be short-term reasons that don't invalidate your long-term strategy.

If your asset allocations relative to your plan are way out of line, it's time to reallocate. When you do that, you get three benefits:

  • You maintain your original risk profile and don't allow it to get out of line.
  • You buy low and sell high, thus adding value to your long-term returns.
  • You are more likely to remain disciplined and to resist knee-jerk reactions to current circumstances or fashionable opinions.

How often should you re-balance? Roughly once a year is optimum. Or you may prefer to do it when your asset allocation gets off target by a predetermined proportion, such as 5 per cent.

You must "doggedly resist the temptation to replace a disappointing fund (or share) with last quarter's hero," Melton advises. "Endless pruning of so-called weeds is unlikely to improve performance. And chasing last period's stellar achiever is a proven way to become a loser.

"If you believe (against mounting evidence to the contrary) that management can add value, you must give your selected manager a little slack time for his strategy to pay off."

How often should you re-evaluate your strategy?

Unless there has been a major change in your financial situation, objectives, time horizon or risk tolerance, you should only alter your asset allocation in response to new market opportunity or information.

As an example of the latter, there's the study produced some years ago by Eugene Fama and Kenneth French showing how superior results could be achieved by pursuing a small company/value strategy. This information was fundamental and important enough to justify a total shake-up of existing portfolios.

But such insights are rare. Avoid reacting "to every half-baked theory that appears," Melton says. Don't be the first to try out every new investment idea. Let others blaze the way. "Remember it takes a long time to make up for a dumb mistake."

Re-balance either by switching, or by directing new funds available for investment into areas that have fallen below the proportions you desire.

Melton says successful global investment "is a lot like gardening both require patience, discipline and faith.

"Your periodic reviews of share and fund performance should be seen as an opportunity for fine tuning and occasional modest course corrections, not radical revision and second-guessing."

In a future issue of On Target, I'll have more to say on how to go about selecting investments for your international portfolio.

By Martin Spring in On Target, a private newsletter on global strategy