Is International Investing a Pointless Exercise?

by: John Christy posted on: March 08, 2007 | about stocks: DGT / EEM / EFA / IOO

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When markets blow up - and rise again from the ashes as they are doing now - it can often seem like international investing is a pointless exercise. Why bother diversifying if the world is increasingly correlated and moving in the same direction anyhow?

Well, there are plenty of great reasons to bother. Mainly it’s in the form of the greater opportunity set that arises when you look overseas. But it’s also important to remember that correlation is only one of the variables in the portfolio risk formula. You can still benefit from diversification even if correlations are rising.

This paper is a little old, but the lesson for today’s markets is fresh. Meir Statman and Jonathan Scheid do a great job explaining why global diversification still matters. Below is an abstract of the October 2004 paper entitled "Global Diversification":

Correlations between the returns of U.S. stocks and international stocks were higher recently than in the past, reaching 0.86 during the 60 months ending in December 2003. Today's investors note the high correlations between U.S. and international stocks and doubt the benefits of global diversification.

We argue that the benefits of global diversification remain high and that the correlation between U.S. and international stocks is a misleading measure of the benefits of global diversification. This is for two reasons. First, the benefits of global diversification depend not only on the correlation between the returns of U.S. and international stocks but also on the standard deviations of these returns. Second, we tend to have poor intuition about the link between correlation and the benefits of diversification. A 0.86 correlation seems high enough to eliminate the benefits of diversification, but even correlations much higher than 0.86 are associated with substantial benefits. Dispersion of returns is a better measure of the benefits of diversification because it accounts for the effects of both correlation and standard deviation and because it provides an intuitive measure of the benefits of diversification. We present the relationship between correlation, standard deviation and dispersion.

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