Diversification of Portfolios in the Global Financial Market - Essay Example

Diversification of Portfolios in the Global Financial Market Introduction In 1995, the total cross-border capital flow reached $9 trillion, which is about one fifth of the world’s GDP that year (Caruana, 2007). The following year, many countries continued to invest globally, especially on emerging markets. A total capital of approximately $93 billion flowed into Indonesia, Korea, Malaysia, Philippines, and Thailand from all over the world (Park, 2002, pp.141-164). Evidently, investors have become more attracted to taking their risks internationally where the returns are considerably higher. However, their risks did not pay off that year. Instead of getting high returns for their investments, they only saw huge losses, prompting many of them to divert their investments the following year. The Asian financial crisis taught many investors of the real risks associated with the globalization of financial market. While it gives market participants a greater source for revenue on one hand, closer ties among markets exposes them to huge risks on the other. The challenge now is to balance between getting high returns and avoiding big losses. The Concept of Portfolio Diversification Investors often liken focusing one’s investment into a single stock to putting all of one’s eggs in a single basket. When that basket is dropped, most, if not all, of the eggs contained will be broken. Conversely, if a person equally distributes 20 eggs into five different baskets, he will be able to save at least sixteen of them should one basket is dropped. This is how the diversification of portfolios in the global market works. Since almost every financial market today is linked globally, it is natural for investors to put their money abroad. To minimize risks, investors need only to put their eggs on different baskets. Although the international market is very unpredictable, making it difficult to know when and how much to invest, investors can still get profitable returns while minimizing risks through the diversification of their portfolios. Why Globalize in the First Place Many market participants prefer keeping their money inside their country because they know the financial situation of their country much better which allows them to foresee risks much better (Issing, 2000). Also, trading policies in other countries, such as the imposition of high tariffs, and other costs for cross-border transactions make it less desirable for investors to join the global financial market. However, the rate at which stock funds grow overseas offset the risks associated with international investment. Yavas (n.d.) noted that domestic stock funds in the United States went up by 12.6 percent by the time 2006 ended. This might be good enough but it is less than half the total growth of international stock funds that year. This case illustrates that while the globalization of financial market is very risky, it also brings many advantages for investors. Globalization changed the financial market in a number of ways. First, the global financial market has offered investors more sources to borrow from, and thus boosting their potential for growth. The problem of domestic surplus also has its solution in the global market. With a greater number of buyers, investors will be able to sell what no one in their country will be willing to buy. Simply put, with more buyers and sellers now more interlinked with each other, globalization has given the financial market a global scope. With a greater scope arise complexities and more risks and seemingly ironic instances. As countries have become more interlinked, they begin to share similar reactions to economic shocks. While similar reactions may make it easier for market analysts to determine how the world will react to different economic shocks, the presence of varying political and economic systems in the global financial market make external and internal economic forces more unpredictable. Greater unpredictability simply means greater risks. Again, the simple solution to this risk is the placing of eggs into different baskets. One could argue that it is pointless to diversify portfolios in a financial market where countries almost always react in similar ways. However, as Bordo (2000) explains, emerging markets are more susceptible to fluctuations, “bust and booms” he calls them, as the result of “open capital markets.” This implies that while one emerging economy may offer huge returns in a couple of days or weeks, investors still need to diversify their investments because it is difficult to determine how emerging economies will do in the longer runs. Disadvantages of Portfolio Diversification The disadvantages of portfolio diversification in the global market are similar for those in the domestic market. Since investors divide their assets when they diversify their portfolio, they will not be able to get the highest possible returns that the market offers (Roos, n.d.). This low return on investment is intensified during a bull run. When the market is doing extremely good and risk factors are very low, most investors prefer to solidify all their assets into a single investment to get the highest returns there are. Meanwhile, investors who diversify at times miss huge gains when a certain stock performs extremely well. Although a diversified portfolio minimizes risks, it does not completely eliminate them. This applies to the systematic risks associated in both global and domestic financial markets. This type of risk causes the stock prices of investors to go down no matter how diversified their portfolios are. In other words, systematic risks affect the whole market (Investopedia, n.d.b.). This negative sentiment on the whole market could be caused by wars, interest rates, and recession. Flavin and Panopoulou (2006) identified that investors in an international market can eliminate the risks associated with a specific country but they cannot altogether avoid the risks on the global market during times of recession and other economic and political crisis. Benefits of a Well-Diversified Portfolio Before investors take on the global market, there is a need for them to understand the risks associated with international investment. First, not all countries have economic and fiscal systems that fit global scope. Park (2002) attributes the cause of the Asian financial crisis in the mid-1990’s to the “inefficient financial system” of Indonesia, Korea, Malaysia, Philippines, and Thailand. This problem is not only caused by each of those countries’s government but also comes from their poor financial structure. Back then, Asian countries were not yet ready for the influx of foreign investments and showed little or inefficient response to the opportunities that the international community has offered them. Although there are no statistics which indicate the total losses for individual investors during the Asian financial crisis, one could logically deduce that those who focused their investments on Asia suffered greater losses than those who spread their portfolios in different markets. Diversification of portfolios has long been recommended by market participants and analysts to minimize the risks associated with international investment (Yavas, n.d.). International diversification is made even more necessary by the fact that players in the global financial market are largely dependent upon each other. If one firm or country does better, it could make the rest of the global financial market perform better. Same goes conversely. Not Every Portfolio is Created Equal International diversification of portfolios is one of the safest strategies for investing abroad. However, its benefits are not equal for all investors or for all investments. Those who invest in emerging markets often get higher returns than those who invest in already developed countries (Driessen, 2007, pp.1693-1712). Consequently, returns for investments on higher risk economies are greater than in economies which are considered “safer.” The performance of countries in the global financial market, especially those with emerging economies, is largely dependent upon those of the more developed countries. In 2008, Asia suffered a total loss of $9.8 trillion when the global market went down (Asian Development Bank, 2009). Experts trace the failure to the collapse in the American and European market. Since global market is not only dependent on individual stocks but is dependent on other countries as well, it is far more complicated and risky compared to the domestic market. This is primarily one of the reasons players in the global market diversify. Risked is reduced when assets in a portfolio are diversified (LastBull, 2009). Five Baskets for Ten Eggs: Over-diversification of Portfolio in the Global Market Although it is good to diversify, there will come a point when adding another item into a portfolio will no longer do any good, especially in the global market. having too many funds in a portfolio will only create “additional bookkeeping and tax headaches” but can no longer protect one from market risks or add more returns to a portfolio (Morningstar, 2007). This is especially true when investing in other countries. While technology does make the monitoring of stocks more efficient, one could not escape high tariffs imposed by some countries on foreign investors. It is difficult to determine the ideal size of a portfolio in the global financial market. However, in the United States, where stocks are more susceptible to changes, many investors hold about 20 to 30 stocks (Investopedia, n.d.a). Conclusion Portfolio diversification does not totally eliminate risks but it does minimize them. Although one should not diversify during a bull run, the world economy is very unstable so consolidating investments is often not the better choice. Investors need to put some of their assets on emerging markets since they offer bigger returns. However, emerging markets are more prone to fluctuations so investors also need to put some of their assets on more stable markets, even if the returns there are not as high. The globalization of financial markets not only makes portfolio diversification more desirable but a necessity as well. Reference List ADB (Asian Development Bank), 2009. Global financial market losses reach $50 Trillion, says study. Asian Development Bank, [online] 9 March. Available at: http://www.adb.org/media/Articles/2009/12818-global-financial-crisis/ [Accessed 12 March 2010]. Bordo, M.D., 2000. The Globalization of International Financial Markets: What can history teach us? International Financial Markets: The challenge of globalization. Texas A and M University, College Station Texas 31 March 2000. Rutgers University: New Jersey. Caruana, J., 2007. Global financial market risk—Who is responsible for what? In: IMF, Conference on Financial Stability. Berlin 30 May 2007. International Monetary Fund: Washington, D.C. Driessen, J., 2007. International portfolio diversification benefits: cross-country evidence from a local perspective. Journal of Banking &Finance, 31 (6), pp.1693-1712. Flavin T., & Panopoulou, E., 2006. International portflolio diversification and market linkages in the presence of regime-switching volatility. IIIS Discussion Paper No. 167. Investopedia, n.d.a. What is the ideal number of stocks to have in a portfolio? [Online] Available at: http://www.investopedia.com/ask/answers/05/optimalportfoliosize.asp [Accessed 12 March 2010]. Investopedia, n.d.b. Systematic risk. [Online] Available at: http://www.investopedia.com/terms/s/systematicrisk.asp [Accessed 12 March 2010]. Issing, O., 2000. The globalisation of financial markets. European Central Bank, [Online] 12 September. Available at: http://www.ecb.int/press/key/date/2000/html/sp000912_2.en.html [Accessed 12 March 2010]. LastBull, 2009. Disadvantages of over diversification [Online] 13 August. Available at: http://lastbull.com/disadvantages-of-over-diversification/ [Accessed 12 March 2010]. Morningstar, 2007. Don't spread your portfolio too thin. MSN Money, [Online] 29 January. Available at: http://articles.moneycentral.msn.com/Investing/Morningstar/ DontSpreadYourPortfolioTooThin.aspx [Accessed 12 March 2010]. Park, J.H., 2002. Globalization of financial markets and the asian crisis: some lessons for the third world developing countries. Journal of Third World Studies, 19 (1), pp.141-164. Roos, D., n.d. How investment diversification works. [Online] Available at: http://money.howstuffworks.com/personal-finance/financial-planning/diversification7.htm [Accessed 12 March 2010]. Yavas, B.F., n.d. Benefits of international portfolio diversification. Graziadio Business Report, [Online] Available at: http://gbr.pepperdine.edu/072/diversification.html [Accessed 12 March 2010]. Read More