International Diversification: Why It Still Makes Sense
by Bernard R. Horn Jr.
In November 1983, I wrote an article for the AAII Journal about the benefits of international diversification. At that time, very few investors even considered international diversification as an investment option. In almost 30 years since that article was written the world has changed.
In 1983 there were about 23 developed investable markets; in 2010 there are nearly 100! Countries that were not part of the market economy (particularly Russia and China) are not only market economies, but are arguably drivers of the fortunes of many companies worldwide. Yet, during times of crisis, the benefits of global diversification are called into question. This article serves to address this concern.
In this article
- The Rise and Fall of Correlations
- Bear Market (Short-Term) Correlations
- Long-Term Correlations
- Emerging Market Returns and Correlations
- Conclusion
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The Rise and Fall of Correlations
Only in the world of finance do fundamental theories often fall into question when faced with disaster or crisis. Such was the situation during the 2007–2009 recession, when the correlation of equity markets appeared to approach parity—and the benefits of diversification were called into question. The Wall Street Journal propagated this debate with a July 10, 2009, article by Tom Lauricella, “Failure of a Fail-Safe Strategy Sends Investors Scrambling,” which highlighted selected short-term correlation data points.
Correlation is computed as a correlation coefficient, which ranges from –1 to +1. Two random variables (e.g., security prices) are positively correlated if as one variable moves up or down, the other variable moves in lockstep directionally. They are negatively correlated if high values of one variable are associated with low values, or opposite movements, of the other. In portfolio management, finding investments that have low or negative correlation with each other offers the chance for better diversification.
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Discussion
Great material! How can SI Pro expand to address emerging markets?
posted over 2 years ago by Stephen from California
Correlation isn't an underlying physical constant to be observed, measured and relied upon. It's a characteristic reflecting underlying market attributes. To the extent that investors view factors such as Europe's common currency problems, U.S. structural deficits and China's efforts to curb inflation as differentiating characteristics then correlation among markets will be lower. Free trade, converging regulatory and tax regimens and coordinated currency actions are examples of what may lead investors to view markets as constituting a unity, thereby driving correlations higher. Early on the author acknowledges the growth of investable markets from 23 to nearly 100, which itself is a symptom of growing uniformity of economic conditions throughout the world. Future correlations or lack thereof among markets will be a reflection of how investors view the world in terms of converging or diverging economic, tax, regulatory, legal and monetary conditions. It would be interesting to see exactly why correlations rise to such extremes during crisis conditions as described in this article and whether there are investment strategies that could be devised to anticipate and exploit those causative factors.
posted over 2 years ago by Paul from Oklahoma
More than just the number of investable countries has happened since 1983. What role does significantly increased globalization play in the apparent increase in correlations between developed and developing markets?
posted about 1 year ago by Thomas from California
