Analyzing the impact of geographical diversification on portfolio performance

The portfolio theory, which originated in the 1950s, pointed out that portfolio diversification allows investors to reduce risk. However, in addition to sector diversification, geographical diversification has been considerably less emphasized in equity investment evaluation. Our study contributes to this area. The calculations were conducted over two periods: 2008-2013 and 2014-2019. We constructed our portfolio using only exchange-traded funds (ETFs). We created two portfolios: one geographically diversified and the other focused exclusively on European markets. The geographically diversified portfolio comprised the IEV (iShares Europe ETF), EWH (iShares MSCI Hong Kong ETF), and EWZ (iShares MSCI Brazil ETF) portfolios. For our analysis, we used an approach based on the Monte Carlo simulation. The simulation calculated the Sharpe ratio of the portfolios, annualizing the metrics using the 252 trading day approach. We performed 10,000 iterations to ensure the robustness and reliability of our model. In the first period (2008-2013), we found that the geographically diversified portfolio showed higher volatility and generally lower risk-adjusted returns than the nongeographically diversified portfolio focused on Europe. Conversely, in the second period (2014-2019), the geographically diversified portfolio outperformed the nongeographically diversified portfolio in terms of risk-adjusted returns, suggesting that geographic diversification is preferable in certain market environments, particularly during periods of economic growth. In conclusion, investors should explore the potential of geographic diversification.