International Diversification: Rising Correlations

(MoneyWatch)  As you may know, I'm a fan of challenging the conventional wisdom in investing. There was an article in The Wall Street Journal on Friday that discussed one of these bits of conventional wisdom: that asset correlations move toward one during periods of negative market conditions. Kevin Grogan, my colleague at Buckingham Asset Management, did some quick research on this and found that this effect is not nearly as pronounced as some make it sound.

Correlation measures the strength of the linear relationship between two variables. In investing, if the correlation between two asset classes is low, you can combine the assets into a portfolio with lower risk than the individual asset classes.

The statistics below show the correlation coefficients for the U.S. equity market (as represented by the CRSP Deciles 1-10 Index) and the international equity markets (as represented by the MSCI EAFE). The monthly correlation over the entire time period (January 1970 - December 2008) is shown, as well as the correlation in down markets.

• International Equity Correlation to U.S. Equity in All Months -- 0.58
• International Equity Correlation to U.S. Equity in Down Markets -- 0.60

While correlations rise in down markets, they don't rise dramatically as is the conventional wisdom. If correlations all rise towards one during down markets, we would expect a much larger difference between the down market correlation and the correlation across all months.

It's said that diversification is the closest thing to a free lunch in investing. As we saw in 2008, global diversification doesn't guarantee positive returns year in, year out. It's important to note that correlations aren't static and will move around. In 2008, the correlation between the U.S. and international markets wasn't exactly 0.60; it was much higher. There have been and could be relatively long time periods in the future where correlations rise to much higher than the historical average, but those invested for the long term shouldn't be concerned about these short-term fluctuations.

If you're concerned about short periods of rising correlations, you should have an allocation to high-quality fixed income assets to reduce the risk of the overall portfolio. This will help allow you to ride out periods of high correlation and take advantage of the benefits that generally come to those who have globally diversified equity portfolios.

In my next post, we'll take a look at how a diversified portfolio has performed over the long run.