Swedroe: Why Int'l Diversification Works

October 24, 2018

As the director of research for Buckingham Strategic Wealth and the BAM Alliance, I was recently asked to comment on columnist Mark Hulbert’s article “International stocks provide the least protection just when investors need it most.

Hulbert noted: “U.S. stocks’ performance so far this year offers a perfect illustration of why investors should not exaggerate the benefits of international diversification. When the U.S. stock market plunged more than 10% in late January and early February, for example, international stocks lost even more. Far from cushioning the fall for investors, they made things slightly worse. When the U.S. stock market again fell sharply, between Mar. 9 and Apr. 2, international stocks also fell. Though this time they didn’t fall as much as U.S. equities, the cushion they did provide was scant comfort.”

He concluded: “In both cases, international diversification did not live up to its advance billing as providing a ‘free lunch’ of reducing portfolio volatility while forfeiting very little return in the process.”

To be fair, he did add: “These two instances by themselves add up to little more than anecdotal evidence. But it turns out that, historically, what happened in these cases is more the rule than the exception. What then accounts for the ‘free lunch’ narrative that is widely associated with international diversification? Because, on paper, such diversification is supposed to work a lot better: Even though international stocks exhibit relatively little correlation with domestic stocks, their return over the long term is quite similar. A portfolio divided equally between domestic and international stocks should therefore produce the same return as a domestic-only portfolio but with significantly less volatility.”

Hulbert went on to explain: “The problem is that the correlation between domestic and international stocks is not constant. It instead shifts with the bull and bear cycle of the market itself: The correlation is lowest when the U.S. market is rising, and highest when U.S. equities are falling. As a result, international stocks provide the least diversification precisely when investors need it most—when U.S. stocks are declining. And when U.S. stocks are rising, and investors don’t need or want any diversification, international stocks provide it in spades.”

Where Hulbert Goes Wrong

While diversification has been rightly called the only free lunch in investing—a portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country held in isolation—the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose towards 1. Many investors, and apparently Hulbert, took away the wrong lesson from what happened—that global diversification doesn’t work because it fails when its benefits are needed most. This is wrong on two fronts.

First, the most critical of lessons that should have been learned is that because correlations of risky assets tend to rise toward 1 during systemic global crises, the most important diversification is to ensure your portfolio has a sufficiently high allocation to the safest bond investments so that your overall portfolio’s risk is dampened to the level appropriate to your ability, willingness and need to take risk. (If you’re interested in learning how to determine that, read The Only Guide You’ll Ever Need for the Right Financial Plan.)

The reason is that, during systemic financial crises, the correlations of the safest bonds to stocks—while averaging about zero over the long term—tend to turn sharply negative when needed most, as they benefit from not only flights to safety but from flights to liquidity.

The other wrong lesson investors took away, and what Hulbert missed in his article, is that they failed to understand that, while international diversification doesn’t work necessarily in the short term, it does work eventually.

This point was the focus of a paper by Clifford Asness, Roni Israelov and John Liew, “International Diversification Works (Eventually),” which appeared in the May/June 2011 edition of the Financial Analysts Journal.

They explain that those who focus on the fact that globally diversified portfolios don’t protect investors from short systematic crashes miss the greater point that investors whose planning horizon is long term (and it should be, or you shouldn’t be invested in stocks to begin with) should care more about long-drawn-out bear markets, which can be significantly more damaging to their wealth.

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