Why Diversification
Diversification across asset classes is one of the core investment principles. By spreading out assets across a range of asset classes with varying degrees of correlation, one can reduce the overall risk to the portfolio (because a downturn in one asset class is likely to be ameliorated by the returns of the other less-correlated investments). And while many people diversify assets by investing in both U.S. and international equities, a combination of increasing correlations between U.S. and international stocks and relative underperformance by international stocks might have some wondering about whether they are actually adding value to the portfolios through international diversification.
The Problem with Diversification
A problem for investors looking to use international stocks to diversify their equity holdings has been high correlations between U.S. and international stocks in recent years. For example, between 2019 and 2021, the correlation between U.S. and developed market (ex-U.S.) stock returns was 0.93 and the correlation between U.S. and emerging markets was 0.82. Both of these figures are significantly higher than they have been in the past, reducing the international stocks’ diversification benefits in case of a market downturn.
Should You Diversify?
However, historical correlations suggest that international stocks could provide increased diversification benefits in the future. For example, as recently as 2019, the correlation between U.S. and developed market stocks was below 0.8 and the correlation between U.S. and emerging market stocks was less than 0.6. And looking back further, correlations between U.S. and non-U.S. stocks were as low as 0.12 during the 1970s, 0.29 in the 1980s, and 0.54 in the 1990s, making them significantly more valuable as a portfolio diversifier (of course, there is no guarantee that these historical conditions will return). Also, those looking for equity diversification could also look to emerging markets, which are typically less correlated with the U.S. than are developed markets.
In the end, having a diversified portfolio of assets with low correlations means that some portions of a portfolio will necessarily underperform others. And so, while some people might be frustrated by the recent underperformance (and higher correlations) of international markets compared to the U.S. in recent years, a return to lower correlations between the asset classes could increase the value of international stocks as a portfolio diversifier!
Diversification across asset classes is one of the core investment principles. By spreading out assets across a range of asset classes with varying degrees of correlation, one can reduce the overall risk to the portfolio (because a downturn in one asset class is likely to be ameliorated by the returns of the other less-correlated investments). And while many people diversify assets by investing in both U.S. and international equities, a combination of increasing correlations between U.S. and international stocks and relative underperformance by international stocks might have some wondering about whether they are actually adding value to the portfolios through international diversification.
The Problem with Diversification
A problem for investors looking to use international stocks to diversify their equity holdings has been high correlations between U.S. and international stocks in recent years. For example, between 2019 and 2021, the correlation between U.S. and developed market (ex-U.S.) stock returns was 0.93 and the correlation between U.S. and emerging markets was 0.82. Both of these figures are significantly higher than they have been in the past, reducing the international stocks’ diversification benefits in case of a market downturn.
Should You Diversify?
However, historical correlations suggest that international stocks could provide increased diversification benefits in the future. For example, as recently as 2019, the correlation between U.S. and developed market stocks was below 0.8 and the correlation between U.S. and emerging market stocks was less than 0.6. And looking back further, correlations between U.S. and non-U.S. stocks were as low as 0.12 during the 1970s, 0.29 in the 1980s, and 0.54 in the 1990s, making them significantly more valuable as a portfolio diversifier (of course, there is no guarantee that these historical conditions will return). Also, those looking for equity diversification could also look to emerging markets, which are typically less correlated with the U.S. than are developed markets.
In the end, having a diversified portfolio of assets with low correlations means that some portions of a portfolio will necessarily underperform others. And so, while some people might be frustrated by the recent underperformance (and higher correlations) of international markets compared to the U.S. in recent years, a return to lower correlations between the asset classes could increase the value of international stocks as a portfolio diversifier!
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