International diversification is as important as ever.
The World Is Flat: A Brief History of the Twenty-First Century is a national best seller by Thomas L. Friedman. The book was published in 2005. The title is a metaphor for viewing the world as flat or level in terms of commerce and competition, as in a level playing field—or one where all competitors have an equal opportunity. Friedman makes the case that regional and geographical divisions are becoming increasingly irrelevant. From an investment standpoint, this trend to "globalization" supposedly lessens the need for global diversification. The financial media has carried so many stories on this theme that it seems this recommendation threatens to become conventional wisdom. However, before we allow this idea to guide our investment decisions, we can check the historical evidence.
To test the hypothesis that globalization has led to a reduction in the benefits of global diversification we can examine the historical correlations of returns between the S&P 500 Index (a domestic large-cap index) and the MSCI EAFE Index (an international large-cap index). We have data for the MSCI from 1970 through 2007. We will split the 38-year period into two equal 19-year periods to see if there is a trend toward rising correlations.
- For the first period, 1970-88, the annual correlation of the S&P 500 Index to the MSCI EAFE Index was 0.623.
- For the following period, 1989-2007, the annual correlation actually fell slightly to 0.614.
We can also examine the correlation data for international small-caps. Historically, international small-cap stocks have had lower correlation to U.S. stocks, making them superior diversifiers of the risks of domestic equities.
- For the first period, 1970-88, the annual correlation of the S&P 500 Index to international small-cap stocks was just 0.459-significantly lower than the 0.623 correlation of the MSCI EAFE for the same period.
- For the following period, 1989-2007, the annual correlation actually fell to 0.374-again, significantly lower than the 0.614 of the MSCI EAFE Index for the same period.1
As you can clearly see, there is no trend toward rising correlations. Apparently the benefits of global diversification are as strong as ever.
Given the data, what explains all the noise about a new paradigm where the benefits of global diversification have disappeared? The answer can be explained in one simple word-recency. Recency is the tendency to give too much weight to recent experience, while ignoring the lessons of long-term historical evidence. Before getting into the most recent data, we need to cover two important points.
The first important point is that correlations are not static. They tend to drift in a random manner. For investors, what should matter is the long-term historical evidence. And the longer the time frame, the more confident we can be about the data. Sometimes events occur that impacts both domestic and international equity markets in very similar ways. This is particularly true during periods of crisis like 1973-74 and 2000-02. Then there are other periods when equity markets perform quite differently.
The second important point is that because equity markets do experience periods of high correlation, investors need to hold a sufficient amount of high-quality fixed-income assets to keep the risk of the overall portfolio at a level that is consistent with their ability, willingness and need to take risk. This is the most important of the asset allocation decisions.