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What is geographical diversification?

Geographical diversification definition

Geographical diversification refers to investing in securities from various regions across the world with the primary aim of limiting losses.

According to the US Securities and Exchanges Commission (SEC), diversification is the practice of spreading money among different investments to reduce risk.

Diversification can be achieved by investing across a mix of different types of stocks, bonds, mutual funds or commodities, such as gold or crude oil. That way if you are holding Apple (AAPL) shares at a loss, for example, gains from your investment in mutual funds tracking commodity stocks could reduce your net losses.

But what does geographical diversification mean? Investors use geographical diversification to avoid excessive concentration in a regional market. Financial markets in different parts of the globe do not always move in tandem with one another. Developed markets in the US and Europe may not be correlated with emerging markets like India and China. US investors can look to tap into markets in India for their higher growth rates, in turn Indian investors can allocate a part of their portfolio to US markets for a piece of the world’s biggest economy. 

Let’s look at some geographical diversification examples to understand the definition of geographical diversification better.

Geographical diversification explained 

Financial markets in different parts of the world can be distinct from one another in terms of composition. 

For example, the FTSE 100 (UK100) Index, which tracks the top 100 largest companies listed in the UK, is dominated by banks, energy and healthcare companies taking up over 30% of the index weighting. Meanwhile, as of 31 May 2022, technology companies represented only 1.3% of the UK’s blue-chip index.

In contrast, the US’s benchmark S&P 500 (US500) Index, which tracks the country’s largest 500 companies, is dominated by tech companies, representing over 27% of index weighting, as of 31 May 2022. 

How does geographical diversification work? A UK investor can invest in an exchange-traded fund (ETF) tracking the S&P 500 Index to get exposure to some of the biggest tech stocks in the world, like Apple (AAPL), Alphabet (GOOGL), Amazon (AMZN) and Tesla (TSLA).

Similarly, investors who are bearish on the US stock market given the aggressive monetary tightening policy undertaken by the US Federal Reserve (Fed) in 2022 can look to China where the central bank is on the path of easing interest rates

It must be noted that returns on equity investment are subject to various factors apart from central bank monetary policy. However, this is an example of how investors can diversify their investments by looking to other parts of the world that may not be correlated to their regional markets.

Geographical diversification for corporations 

Geographical diversification is also a part of business plans of most multinational companies. Diversifying factories across regions allows companies to take advantage of low labour costs in some parts of the globe or gain from favourable trade agreements and government policies.

Many companies including Apple (AAPL) and Nike (NKE) have looked to reduce their manufacturing dependence on China by establishing factories in nations like India and Vietnam. 

The geo-political tensions between the US and China are seen as key factors into this growing trend of lowering reliance on China production. Moreover, supply chain risks highlighted during the coronavirus pandemic due to China’s strict zero-Covid policy have accelerated geographical diversification of manufacturing units away from the country.

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