International Diversification Still Works, if You're Patient

The recent financial crisis saw the correlation of all risky assets sharply rise, which led to many saying global diversification was no longer effective in reducing risk. Over the past few years, I have written several posts showing why the benefits of international diversification are as great as ever. It's just that you need to view the issue from the proper perspective -- a long-term one. Clifford Asness, Roni Israelov and John Liew appear to agree with that view in their article "International Diversification Works (Eventually)."

They note that while "critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns .... this observation misses the big picture. Over longer horizons, underlying economic growth matters more than short-lived panics with respect to returns, and international diversification does an excellent job of protecting investors."

Asness and his co-authors analyzed diversification benefits from the perspectives of local investors in 22 countries for the period 1950-2008. They looked at two portfolios:

A local one as represented by the local stock market index
An unhedged (for currency risk), equally weighted global portfolio for all 22 stock market indexes

The following summarizes their findings:

Simultaneous crashes can pose a problem for global diversification in the very short term by creating more severe tail events in global portfolios than in local portfolios. However, this difference is greatest at very short horizons and disappears after 3.5 years.
Over periods as short as one month, the global portfolios' worst cases weren't much different than for the local portfolios.
Over longer horizons, the global portfolios' worst cases were significantly better than those of the local portfolios, and the longer the horizon, the greater the diversification benefit.
The average worst five-year return for the local portfolios was -57 percent (though not all at the same time). When these local portfolios had their worst five-year losses, their global portfolio counterparts lost an average of 16 percent, and the average worst five-year return for the global portfolios was -39 percent.

It's important that you understand that short-term returns tend to be more influenced by short-term changes in risk aversion (when systematic risks appear and investors all around the globe tend to panic and sell at the same time). On the other hand, long-term returns are driven more by economic performance. And long-term economic performance tends to be more variable across countries. Since we don't know in advance which countries will suffer from protracted economic underperformance, international diversification protects investors.

While short-term crashes are scary, painful and occur with greater frequency than most investors believe, ultimately you should care about long-term wealth creation and preservation. Thus, you should care about protecting against the risk that your home country will experience a long, persistent bear market. And global diversification provides the benefit of protection against such risks.

The bottom line is that diversification is probably the only free lunch in investing. And since this lunch doesn't come with any calories, the logical conclusion is to eat as much of it as you can.

Photo courtesy of cometstarmoon on Flickr.
More on MoneyWatch:
Is International Diversification Worth the Costs? Why International Diversification Is Important 4 Reasons Investors Avoid Investing Internationally International Diversification: Does It Still Work? International Diversification: Rising Correlations
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Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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