Global diversification is a must while investing. Indian investors who believe in the infallibility of the Indian equities market, must look at why past research continues to indicate that home country bias is not good.

A key reason why retail investors the world over have assets that are not global diversified is simply home country bias. This is true of Indian investors also. But investing all in the home country is often a default choice, never a deliberate & considered choice. As per visualcapitalist, India makes up only 7-8% of world economy on PPP GDP basis, investors need to ask, why they are ignoring 90%+ of the world markets.

This bias puts investors at a significant risk of wealth erosion – this could come in the form of geopolitical risks, hyperinflation, debt or current account crisis or a simple meltdown in the local markets due to any number of reasons. India is no exception: while it is seen as a (relatively) fast growing and large market economy but nothing guarantees it will not undergo extreme challenges in its journey from here.

The benefits of global diversification are primarily two. Lower risk and higher returns – both are more certain in the long term.

Risk

The first key benefit of global diversification is managing the downside risk. The following two graphs are borrowed from a very helpful paper by Bridgewater on global diversification. Both serve to highlight the fact that any country can go through severe times for extended times.

The first graph shows the depth and duration of the worst drawdowns above cashback across countries since the beginning of the 20th century.

It is important to note that not only the worst drawdowns have been deep across countries but have often lasted across decades.

  • Most of us are familiar with the great depression that hit the US markets in 1929-32.
  • The worst drawdowns in Russia and Germany resulted in 99% and 100% of the wealth being wiped out with Germany taking 47 years to recover while the investors in Russia never came back.
  • Most countries have seen 60% or more drawdowns taking anywhere from 10-30 years to recover with many like Japan & Italy still recovering.
  • The drawdowns have happened across decades and for a variety of reasons – war (Russia, Germany, and France), inflation (Australia, UK, Norway, and Spain), deflation (Japan), balance of payments crisis (Brazil), political turmoil (Italy).

The second graph below shows that the extent of such drawdowns is significantly reduced both in terms of the extent of the slide as well as the duration which it takes to recover. The red line below is an equal weight portfolio. It neither dives as deep as the individual country portfolios nor is as wide (implying faster recovery) as them.

Blackrock maintains a useful and simple dashboard to track the most significant geopolitical risks across the globe. The south Asia graph for e.g. is currently showing a significant peak!

Returns

The ranking between countries/regions in terms of returns is an every changing list – no country consistently over performs over long periods of time. Even if a particular geography manages to do that for a few years on the trot, it typically corrects and underperform subsequently. The graph from Blackrock below points to mean reversion being the rule in the long run.

The Bridgewater paper referenced earlier highlights the benefits of global diversification from the returns point of view. In the graph below, the red line (which equal weights across the spectrum of countries) for equities (left graph) ends up beating all countries except one while for bonds (right graph), the red line beats all but two countries. In both the cases, the equal weight portfolio (i.e. red line) also displays much less volatility than any of the individual countries involved.

Global diversification also helps to improve the chances of finding undervalued markets. Higher valuations increase the probability of depressed forward returns and vice versa.

The following chart from a 2016 research paper by Star Capital ratio highlights. Returns are on the y-axis and CAPE ratio (a popular valuation measure – cyclically adjusted price to earnings) on the x-axis. The overall chart slides down (i.e. decreasing returns over the next 10-15 years) as the valuations enter the expensive territory.

The trend is true for all countries (blue dots), S&P 500, Sweden, Denmark. Japan has yet to recover from the sky high valuations (CAPE of ~80) it hit during the early 90’s i.e. even after 4 decades.

Stable investor argues that the above chart holds true for India too; it looked at the history of Nifty 50 between early-1999 to late-2018, i.e. full 20 years. Instead of CAPE, it plots PE against future returns and finds a very similar trend. Notice that the lines get sharper in the second graph implying more certainty in decreasing returns with increasing P?E as you look over long time periods.  

Given that the Indian market is arguably on the expensive side with Nifty 50 PE running around 27 currently, can you afford to only invest in India & risk poor future returns?

Final comments

Putting all eggs in one basket (country) is a very risky proposition especially in the long term. Global diversification helps to improve the return to risk ratio.

Do note that global diversification does involve taking currency risk especially when all your expenses are in your home country. However, this is a subject I hope to dive into at some later point in time.

You can read the next set of posts in this series below.