If you pick up any finance textbook, it’ll tell you that international diversification is good. International diversification is good because the returns on stocks in different stock markets, in different regions, are supposed to be un-correlated, hence falling markets in one region can be offset by growth in other regions. The key phrase in that sentence is supposed to be. A brief look at the chart below illustrates why:

Click on the chart to enlarge

I compiled monthly returns data on the major indices from 11 different countries around the world for the past decade, going back to Jan 2000. Next, I calculated the correlation between the S&P500 and each of the foreign indices for a rolling 2-year period, starting in Jan 2002 and that is what is plotted on the chart above.

Having seen the chart above, anyone who hears someone extolling the diversification benefits of investing abroad, should be asking “What benefits?”. Yes, investing in emerging markets will likely give you exposure to stronger growth stories – that is not my argument. But the claim that investing in a variety of regions reduces your portfolio risk is no longer as valid today as it was before 2008. If you were holding a core portfolio invested in US stocks and decided to “diversify” into any of these 11 regional stock markets, a correlation with the S&P500 that hovers around 0.8-0.9 is more likely going to result in a concentration of risk, instead of diversification.

In fact, this phenomenon has been recognized by economists and researchers who point out that in times of market stress, correlations break down and go to 1. That is what we see happening in the chart in Oct 2008 as the correlations quite literally “collide”. However, the qualifier “in times of market stress” should be questioned. The past year for stock markets has been one of prosperity and phenomenal growth – nothing that could remotely be labelled as stressful. Despite that global stock market correlations have not declined after that spike in 2008, as would have been expected. Does this imply that global stock markets have now become permanently linked, with correlations flat-lining around 0.85 as seen from the chart? It might be time to re-write those finance textbooks.

Disclosure: Long Market

Image Credit: Katrina.Tuliao under a Creative Commons license

Disclaimer: Views and opinions expressed on above are those of the author alone and do not in any way represent the official views, positions or opinions of the employers – both past or present – of the author in question, or any other institutions and corporations associated with the author. Neither the information nor any opinions contained or expressed above and elsewhere on Young & Invested constitutes or should be construed as a solicitation or offer by Young & Invested to buy or sell any securities or other financial instruments or to provide any investment advice or recommendations. Young & Invested shall not be liable for any claims or losses of any nature, arising indirectly or directly from use of the information on or accessed through the site. Please see full disclaimers here.