After the Market Crisis: Does Diversification Still Work?

If you read my recent post on why U.S. investors should consider having exposure to international stocks and you still aren’t sold on the benefits of international diversification, you may have this objection: Diversification didn’t work during the last market crisis.

This is certainly true, but it’s not an argument for staying close to home. As I write in my Market Perspectives paper, “Innocents Abroad: The Case for International Diversification,” it’s true that during the financial crisis about the only two asset classes that provided any real hedge were safe haven bonds, including Treasuries, and gold. Virtually all other risky assets moved in lockstep.

Even in the immediate aftermath of the crisis, correlations remained unusually high as investors fixated on macro events—the European debt crisis, the U.S. fiscal cliff, Greece—that transcended asset classes and geographies.

Looking back before the most recent crisis, we also saw high correlations during earlier periods of stress. For example, in the prelude to the Asian crisis in 1997, the U.S. equity market had a relatively low correlation, around 0.32, with non-U.S. stocks. That correlation jumped by more than 50% as the world focused on the turmoil in Asia. A similar phenomenon occurred a year later with the Russian default in 1998.

In other words, correlations typically rise during a crisis. Investors, who normally have different time horizons and strategies, all suddenly focus exclusively on the here and now. As everyone’s focus narrows to a single event or issue, risky assets tend to all behave in a similar fashion and benefits of international diversification are more muted. It’s also certainly true that diversification may not protect against market risk or loss of principal.

This all, however, shouldn’t take away from the importance of having a diversified equity portfolio. Why? Periods of crisis – and their associated high correlations — don’t last, and the benefits of diversification are derived, almost imperceptibly, over a multi-year time frame.

According to the basic tenants of portfolio construction, a portfolio that is concentrated in just one market, even a large, diversified market such as the United States, will rarely produce the best long-term risk/reward trade-off. This is because such portfolios are taking on risk that could have been managed with diversification; a well-diversified, global portfolio can help minimize this unnecessary risk.

Indeed, while international diversification is a sensible idea for most U.S. investors, its benefits may be even more likely to accrue in the coming years, given that U.S. stocks are more expensive than their international counterparts and the United States’ relative share of the global economy is declining.

Source: Bloomberg

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.

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