Asset Allocation: Global Asset Management : Diversification

Another aim of global investment is diversification.

The aim of diversification is to reduce risk without causing a corresponding decline in total returns - increasing the risk/return trade-off. Strictly speaking, it has nothing to do with the potential for higher returns in absolute terms.

Diversification - whether international or not - involves picking combinations of assets whose prices behave in different ways. In technical terms this is described as the extent to which two assets' prices are correlated.

Assets with prices which more often than not move in opposite directions are called ‘negatively correlated’. The risk reduction effect of diversification is greatest with this sort of pairing because as one price rises another falls.

But some risk-reduction effects are gained at any time that assets don’t move in the same direction at the same time.

Widening investor choice to include different country's markets increases the potential for picking assets whose returns do not move together - so achieving lower portfolio risk without appreciably lower overall potential returns.

Different country's asset values don’t necessarily move together because different countries have different industrial structures, markets, economic prospects (business cycles), social dynamics and, as a result, different economic fortunes.

However, this isn't always the case and it is obvious that some types of cross-border diversification will have greater risk reduction benefits than others. For example, a US investor will find an investment in Canada less useful ( from a diversification viewpoint ) than an investment in, say, the eurozone; the reason being that the US and the eurozone show less correlation, in terms of the behaviour of their economies, than the US and Canada.