Markets & Economy
How to manage "country risk"
June 04, 2014
Catherine Gordon: Joe, given that economic and political problems can occur in any country or region, what's the best way to manage what's often called country risk?
Joe Davis: I think the best way to manage it would be to adopt a more globally oriented portfolio, whether we're talking about fixed income or equity. I think the narrower ones, say [an] equity portfolio, mean it's really targeted to one individual country, and where one is just exposed to the inherent risk that may be just not shared by other countries around the world. So it's this notion of international diversification, which we think is always critical. But that's particularly stronger for those markets, which are just smaller percentages of world market capitalization. And so you know, investment theory would tell us that the most efficient portfolio is global in nature, which is another way for saying that individual country risks may not be compensated through higher returns over time.
And so you're going to have, just all else equal going forward, perhaps similar returns with greater volatility, the more narrow your equity portfolio. And so the recent slowdowns in emerging markets here or there I think just underscores the fact that having a broader portfolio tends to moderate those individual issues and that's always, I think, a valuable starting point for investors.
Catherine Gordon: Thanks.
Joe Davis: Thank you.
Catherine Gordon: We've also talked recently to Vanguard's chief economist in Europe, Peter Westaway, to get his thoughts on managing country risk, and here's what he had to say.
Peter Westaway: The temptation is to try and see around corners and think, 'this is the area where I can really make money.' But I think the reality even for people that are looking—even for the experts—is it's very difficult to know in advance what's going to happen. And therefore it's really foolhardy for investors to build their portfolio around a particular assumption about how the world's going to turn out. Much more sensible to acknowledge that contributable uncertainty about the world and as a result, hold a diversified portfolio, which effectively hedges your risks against all those different possibilities.
All investing is subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issues by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates.
Stocks of companies in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
Investments in bonds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
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A brief reminder about country diversification from two Vanguard economists
Unexpected economic or geopolitical problems can crop up anywhere around the world. Should investors try to avoid such trouble spots? In a short video, Chief Economist Joseph H. Davis, Ph.D., and Chief European Economist Peter Westaway, Ph.D., explain the importance of remaining broadly diversified.
Also of interest:
- Is the global recovery on track?
- What's ahead for interest rates?
- Time for optimism in Europe?
- Where are emerging markets headed?
- Is China headed for a slowdown?
- All investing is subject to risk, including the possible loss of the money you invest.