The Investment World Is Not Flat

(MoneyWatch) 

With the way all major equity asset classes plummeted last year, you may be wondering if international diversification still matters. When I get asked about international diversification, I almost always think immediately of Thomas Friedman.

In his book The World Is Flat, 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 severe losses experience by all major equity asset classes (and commodities as well) in 2008 seems to support this view. But before you swallow that story, consider the wide dispersion of returns for the first five months of 2009.

• Vanguard Total Stock Market Index Fund -- 4.0 percent
• Vanguard REIT Index Fund -- -8.7 percent
• Vanguard Total International Stock Index Fund -- 12.2 percent
• Vanguard Emerging Markets Stock Index Fund -- 37.3 percent
• PIMCO Commodity Real Return Strategy Fund -- 17.1 percent

Has the investment world suddenly turned round again? No. It was simply never flat to begin with. It's just that many investors don't understand that correlations are not static. Instead, you should understand that sometimes events occur that impact domestic and international equity markets in similar ways. This is particularly true during periods of market crisis like 1973-74, 2000-02 and 2008. However, there are other periods, like the first five months of 2009, when equity markets perform quite differently and the benefits of international diversification become clear.

It is also important for you to recognize that because equity markets do experience periods of high correlation, you need to hold a sufficient amount of high-quality fixed income assets to keep the risk of your overall portfolio at a level that is consistent with your ability, willingness and need to take risk. Getting this right is the most important asset allocation decision you will make.

The bottom line is that international diversification is as important as ever. In fact, it has been said that diversification is the closest thing there is to a free lunch, so you might as well eat a lot of it. And, remember that the greatest diversification benefits are in international small-cap stocks and emerging market stocks.