If you read my recent post on why U.S. investors should consider having exposure to international stocks and you still aren’t sold on the benefits of international diversification, you may have this objection: Diversification didn’t work during the last market crisis.
This is certainly true, but it’s not an argument for staying close to home. As I write in my Market Perspectives paper, “Innocents Abroad: The Case for International Diversification,” it’s true that during the financial crisis about the only two asset classes that provided any real hedge were safe haven bonds, including Treasuries, and gold. Virtually all other risky assets moved in lockstep.
Even in the immediate aftermath of the crisis, correlations remained unusually high as investors fixated on macro events—the European debt crisis, the U.S. fiscal cliff, Greece—that transcended asset classes and geographies.
Looking back before the most recent crisis, we also saw high correlations during earlier periods of stress. For example, in the prelude to the Asian crisis in 1997, the U.S. equity market had a relatively low correlation, around 0.32, with non-U.S. stocks. That correlation jumped by more than 50% as the world focused on the turmoil in Asia. A similar phenomenon occurred a year later with the Russian default in 1998.
In other words, correlations typically rise during a crisis. Investors, who normally have different time horizons and strategies, all suddenly focus exclusively on the here and now. As everyone’s focus narrows to a single event or issue, risky assets tend to all behave in a similar fashion and benefits of international diversification are more muted. It’s also certainly true that diversification may not protect against market risk or loss of principal.
This all, however, shouldn’t take away from the importance of having a diversified equity portfolio. Why? Periods of crisis – and their associated high correlations — don’t last, and the benefits of diversification are derived, almost imperceptibly, over a multi-year time frame.
According to the basic tenants of portfolio construction, a portfolio that is concentrated in just one market, even a large, diversified market such as the United States, will rarely produce the best long-term risk/reward trade-off. This is because such portfolios are taking on risk that could have been managed with diversification; a well-diversified, global portfolio can help minimize this unnecessary risk.