Why it pays to branch out abroad

Adding foreign shares to a portfolio is a useful way to reduce investment risks. Matthew Partridge explains why.

Even in today's globalised world, individual investors have a strong preference for companies listed in their home countries. Around 90% of the shares held by individual Americans are listed on US exchanges, according to the National Bureau of Economic Research, while only a quarter of money held in funds is put into those funds invested in assets outside the US.

On the surface, British investors appear to be a bit more adventurous: around half the money invested in UK-based equity funds is invested in international stocks, according to Investment Association data. However, given that the British stockmarket accounts for only 10% of listed shares around the world by market capitalisation, then this "home bias" is even stronger.

There are understandable reasons why investors prefer to stick with their home market: they're more familar with the companies involved, they don't need to think about issues such as currency fluctuations and they may believe that international investing is more expensive or difficult. However, adding foreign shares to a portfolio is a useful way to reduce risks because it allows them to diversify. British shares will be heavily affected by the strength of our economy and the decisions our government makes.

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However, these factors will have much less impact on other markets, so by spreading your money among different countries you can therefore reduce the impact of UK-specific issues on your portfolio. Moving from a UK-only portfolio to one evenly split between UK and international shares between 1987 and 2000 would have substantially cut volatility, according to research by fund management firm Vanguard.

However, there are limits to the benefits of diversification, because the rising global trade and capital flows means that economies are increasingly interconnected. For example, since the dollar is the worldwide reserve currency, monetary policy decisions by the Fed will have a global impact. The rise of global firms mean that even companies headquartered in one country may get only a small proportion of their sales from that market. The classic example is HSBC, the largest company in the FTSE 100, which gets over 85% of its sales from outside Europe.

Consequently, markets tend to rise and fall together more than than ever before. The FTSE 100 had a 50% correlation with global markets between 1900 and 2000, according to Elroy Dimson, Paul Marsh and Mike Staunton of London Business School. Over the past 15 years, this correlation has risen to 91%, according to Morningstar. This means that while there are still gains to be made from international diversification, they are much less than they used to be.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri