In this series of bite-sized guides, we began by explaining the relationship between risk and return, before getting to grips with the different characteristics of shares and bonds. In this third instalment we look at the relative merits of investing in domestic and overseas markets.

Investment theory suggests a global approach is best because it can give your portfolio the broadest possible representation.

Think of it as the weekly family shop. To get the most out of your trip to the supermarket you go up and down all the aisles, not just the one with the chocolate biscuits or the wine. You might like them but a plate of chocolate digestives accompanied by a rich merlot every meal won’t be good for you in the long run.

It’s a similar argument with investing. Rather than limiting yourself to UK shares and bonds, you’ll probably want your portfolio to be as varied as your diet.

And yet many investors, it seems, like their home comforts. They prefer to keep much of their portfolio invested in their local market, perhaps due to their familiarity with many of the businesses involved. This phenomenon is known in the investment industry as ‘home bias’.

More companies in more countries

So, what do you get when you invest solely in the UK market and how does it compare with a global approach? In a nutshell, you get access to far fewer listed businesses, let alone countries. 

The FTSE All Share Index, which is a well-known index broadly representing the UK stock market, contained 601 companies as of 31 May 2021. That’s a lot of different companies, operating across a full range of industries, from finance and retail to engineering and beyond.

However, the UK market is highly concentrated at the top end, with the ten-largest companies accounting for roughly 36% of the index¹.

By comparison, a Vanguard fund tracking a global index such as the FTSE Global All Cap Index can provide an investor with exposure to almost 7,200 companies. What’s more, the top ten constituents make up just 14% of the index, while the UK market accounts for just 4.1%².

UK companies are global companies

Of course, the UK stock market has a relatively international flavour in its own right – alongside domestically focused businesses it is made up of multinationals with significant overseas earnings.

So, if you invest in the UK market – the FTSE 100 index of leading UK shares, especially – you’ve already got some international diversification baked in anyway. This was evident, for example, from the positive way the FTSE 100 behaved after the 2016 Brexit vote. As the pound fell in response to the vote, it boosted the value in sterling of large UK companies’ overseas earnings.

Still, by tracking a global index, investors can achieve much greater diversification. You’re still getting access to great UK companies, but you’re also getting exposure to the world’s most successful businesses including US tech giants, German and Japanese carmakers, Asian phone makers and national telecoms companies and utilities.

At the same time, you’re gaining exposure to markets as diverse as India, Indonesia, Ireland, Israel and Italy – and that’s just countries beginning with the letter ‘I’!

Which sectors will perform best?

Each individual country has a unique history and access to different natural resources that has left each one with a particular industrial structure. These differences are often reflected in their stock markets and can significantly affect your investment returns.

For example, if you invest in the UK you’ll get more exposure to oil and gas companies, producers of staple consumer goods, banks and insurers than you would in a global portfolio. Conversely, you will get a significantly lower weighting in technology – an area where the UK has minimal large company exposure.

This means that if financial company shares perform well, the UK market is likely to benefit. But if technology leads the way, then UK returns are likely to lag those in the rest of the world, not least US markets.

The problem is that you cannot know in advance which sectors will perform best over any future time frame. So you don’t know how these unintended sector biases might ultimately affect your returns.

Global or local?

At Vanguard, we favour a global approach. But human nature leads most investors to prefer a degree of home bias – and the extent of that bias will depend on your own circumstances.

The good news is that you have options.

Our LifeStrategy funds, for example, give you exposure to the world’s stock and bond markets, but with a home bias – i.e. higher UK weightings than you would get based on the respective size of each market.

We also offer a range of building-block funds offering pure access to global markets. And if you want to keep it local, you can invest in our funds that focus just on UK shares or bonds.

 

¹ As at 31 December 2021.

² As at 28 February 2022.