For those of you who are familiar with some of my research, you know how I have railed against people overselling the concept of “Global Diversification”. While there is an obvious benefit to diversifying your investments, it is not fair to mislead investors about the degree of benefit. It goes something like this.
Investors are sold a package of international investments with the promise of global diversification. Correlation is the measure usually touted and the international investments, we are told, have a low average correlation, say 0.30.
But this is how it works. When the U.S. market is down, the correlation increases, say to 0.6, which is bad news because it means other markets go down with the U.S. That is, you are disappointed that the correlation was higher than the 0.3.
When the U.S. market is up, correlations decrease, say to zero. This means that while the U.S. is going up, you are being punished by low returns in other markets. That is, you are disappointed that the correlation was lower than the 0.3.
Yes, the average is 0.3 (0.6 + 0.0)/2 — but you are worse off than you thought.
In this video blog shot on January 22, 2009, I argue that the current episode is an extreme example of why there are limited benefits to global diversification. All major equity markets dropped like stone in 2008. There was no diversification.