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Why International Diversification Is Important

In my last post, I mentioned that currency risk is present for international investing regardless of whether you choose to invest abroad:
  • If the dollar rises in value, foreign stocks may underperform.
  • If the dollar falls in value, the cost of maintaining your lifestyle increases.
Financial economists recommend adding international assets to portfolios because they actually reduce risk. The reason is that international equities don't move in perfect tandem with domestic equities. Hedging currency risk would increase the correlation of returns, and the higher the correlation, the lower the diversification benefit. However, hedging currency risk reduces the volatility of the asset, and the impact on volatility is greater than the impact on correlation of returns. The result is that hedging actually produces a very small reduction in overall portfolio volatility (though the reduction is statistically insignificant).

Meir Statman's study "Hedging Currencies With Hindsight and Regret" covered the period 1988-2003 and found that hedging currency risk between the Russell 3000 Index and MSCI EAFE Index increased correlation of returns from 0.61 to 0.71. However, the standard deviation (volatility) of a 60 percent equity (30 percent Russell 3000 and 30 percent EAFE) and 40 percent fixed income portfolio (divided between U.S. Treasury bills and long-term Treasury bonds) would have been reduced from 8.84 to 8.73. Thus, the impact of hedging on volatility was greater than its impact on correlation of returns.
However, there's the simple logic of not having all your eggs in one basket, no matter how safe that basket may appear. "Foreign currencies provide an element of diversification against domestic budgetary, fiscal and monetary risks. For example, domestic inflationary pressures are usually bad for domestic interest rates and often lead to a depreciation of the currency. In this scenario, an inflationary rise in interest rates is bad for domestic bonds and stocks, but good for foreign currencies. Although the value of foreign currencies is volatile, they bring some risk diversification to a domestic portfolio."

You shouldn't make the mistake of confusing familiarity with safety. An important component of a prudent investment strategy is having a significant portion of the equity allocation being devoted to international markets, and the currency risk should be unhedged.

More on MoneyWatch:
4 Reasons Investors Avoid Investing Internationally International Diversification: Does It Still Work? Lessons Learned From the Greek Tragedy How Not to Create a Fortune Can Investing Be Too Simple?

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