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Is International Diversification Worth the Costs?

The benefits of international diversification have been questioned ever since the mid-1990s when correlations between U.S. and international equities began to rise. The financial crisis that began in late 2007 provided more fodder for the skeptics. Are the incremental costs of international investing (higher fund expenses, greater trading costs and issues related to foreign tax credits) no longer worth the benefits? A new study by Dimensional Fund Advisors shows that international diversification is still important.

Before examining the evidence, it's important to understand that investors face two different types of risks: systematic and unsystematic risks.

Systematic Risk Systematic risks can't be diversified away. The market must reward you for taking systematic risk, or you wouldn't take it. That reward is in the form of a risk premium: a higher expected return than could be earned by investing in a less risky instrument.

Unsystematic Risk Unsystematic risks are idiosyncratic (unique) risks that can be diversified away, such as the risk of owning a single stock, sector fund, or the equities of a single country or region. Since unique risks can be diversified away, you're not rewarded with a risk premium for accepting this type of risk. Prudent investors only take risks for which there's an expected risk premium. Thus, you should only invest in vehicles that eliminate (or at least minimize) unsystematic risk.

Crises and Correlations The historical evidence demonstrates that there's a strong tendency for correlations of international equities to increase in falling markets. This pattern has led some to believe that international diversification fails when needed most. However, this tendency doesn't mean all markets either fall or recover at the same rate. While global equity diversification can't protect you from systematic risks that cause global market movements, it does protect against additional idiosyncratic risk.

Marlena Lee, research associate at Dimensional Fund Advisors, examined the evidence on the benefits of international diversification. Her study covered the period from 1980 through June 2010. The following is a summary of her findings:

  • On average, more than 60 percent of a country's total monthly variance is due to idiosyncratic country risk.
  • Contrary to popular opinion, idiosyncratic variance increased by about 40 percent over the past 30 years.
  • Closer inspection reveals that the decline in the percent contribution of idiosyncratic risk is due to an even greater increase in market volatility - market volatility almost doubled during the period.
  • The benefits of international diversification are actually greater during periods of high market volatility - idiosyncratic risk levels tend to be higher in months with extreme market movements, either up or down. On average, idiosyncratic risk and cross-sectional dispersion tend to be about 25 percent higher in the highest and lowest return quintiles. Thus, the benefit to global equity diversification tends to be amplified in down markets.
  • The benefits of reducing exposure to a single country increases as the investment horizon is extended. To the extent that investors care about returns over periods longer than one month, monthly risk measures understate the importance of diversification over longer horizons.
While it's true that there has been a recent decline in the relative importance of idiosyncratic risk, this is due to unusually high market volatility, not a downward trend in idiosyncratic risk. If shocks to market volatility aren't permanent, their negative impact on the relative importance of idiosyncratic risk should be temporary.

Unfortunately, many investors took the wrong lesson from the financial crisis and abandoned the idea of international diversification. The right lesson is that you need to be aware of both the benefits and limitations of global equity diversification. While international diversification can minimize idiosyncratic risks, systematic risk will always contribute to the risk of equity portfolios no matter how broadly you diversify country risks. Thus, the most important diversification is to make sure your allocation to very high quality fixed income investors is sufficient to dampen the portfolio's risk to an acceptable level -- not exceeding either your ability, willingness or need to take risk. And finally, you should be aware that the largest benefits are gained by including allocations to international small-cap stocks as opposed to the large-cap stocks (such as the MSCI EAFE Index) typical of most investors.

More on MoneyWatch:
International Diversification: Rising Correlations International Diversification: Does It Still Work? The Investment World Is Not Flat Emerging Markets: Can They Lower Volatility? Diversification Is Still Alive and Well
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