I’m working on two books simultaneously so it’s been tough finding time to write on the blog, but today’s drop in the stock market prompted me to post an observation. I’m not worried about Wall Street’s temporary tantrum because these sorts of things happen every now and then. Actually, the Wall Street panic should make intelligent investors, who own diversified portfolios and who don’t worry about market hiccups, feel superior. That’s the major reason why we divide up our investments among different categories to protect us when some little country in Southeast Asia creates a negative financial chain reaction. Or housing foreclosures cause stock traders to panic. Whatever the reason, it doesn’t matter.
Which brings me to a timely email that a reader sent me concerning diversification. I’ll let you read it and then I’ll respond.
I’ve always respected your financial opinions. Your humor and common sense approach to investing won me over long ago. Now that I’ve buttered you up ;)…here’s my question:
Like you, I believe diversification is important in any portfolio. I try to keep mine balanced among the major asset classes: large, mid and small caps, foreign and emerging markets, cash and/or bonds. But I’m starting to see a trend that is making me wonder if diversifying is really doing what it’s intended to do, i.e., spread risk. It seems that when my assets go up, they all go up. And when they drop, they all drop. The globalization of companies and market exchanges is largely responsible for this, I feel. So how can we truly diversify and spread that risk effectively when national and global markets seem to be in lockstep?
Thanks for your insights on the subject!
A major reason to invest in distant time zones is to reduce the potential volatility of an all-American portfolio. Some investors, such as Ken, have questioned, however, whether diversification protection remains a valid argument since domestic and international stocks have behaved more like cousins than total strangers in recent years.
A report published by the Vanguard Group, entitled , International Equity: Considerations and Recommendations, suggests that the reason for the closer behavior is because European stock markets, which have traditionally behaved more like their Yankee cousin, have been on a tear while Asian stocks, which traditionally have had less correlation with American stocks, have been overshadowed. Here’s an excerpt from the report:
The correlation of U.S. stocks and international stocks has increased over time, and notably so since the mid 1990s. One significant driver for the increased correlation has been the steady decline in the importance of the Pacific region over the last 20 years. Historically, European markets have been more closely correlated to U.S. markets than Pacific markets have been to the U.S. markets. In other words, Pacific markets, and especially Japan, have historically been a significant source of diversification for global portfolios. But, since the 1980s, Europe’s market capitalization has doubled, at the expense of the Pacific region. As a results, the strong diversifying effect of the Pacific region has been muted in the last 10 years.
Even if returns and volatility between U.S. stocks and overseas equities remain similar in the future, the diversification benefit should not disappear. The Vanguard research concluded that a 10% allocation to international stocks has historically reduced volatility of a domestic portfolio by .6% (60 basis points) and the volatility drops 1.5% (150 basis points) if the allocation is 40%. Now that’s something to celebrate on a day like today.