Is the Investment World Flat?

The World Is Flat: A Brief History of the Twenty-First Century is a national bestseller book by Thomas L. Friedman. The book was published in 2005. The title is a metaphor for viewing the world as flat or level in terms of commerce and competition, as in a level playing field —or one where all competitors have an equal opportunity. Friedman makes the case that regional and geographical divisions are becoming increasingly irrelevant.

From an investment standpoint, this trend to “globalization” supposedly lessens the need for global diversification. The financial media has carried so many stories on this theme that it seems that this recommendation threatens to become “conventional wisdom”— an idea that has become so ingrained that few individuals question it. However, before we allow this idea to guide our investment decisions, we can check the historical evidence.

To test the hypothesis that globalization has led to a reduction in the benefits of global diversification, we can examine the historical correlations of returns between the S&P 500 Index (a domestic large-cap index) and the MSCI EAFE Index (an international large-cap index). We have data for the MSCI from 1970 through 2007. We will split the thirty-eight-year period into two equal nineteen-year periods to see if there is a trend toward rising correlations.

• For the first period, 1970–88, the annual correlation of the S&P 500 Index to the MSCI EAFE Index was 0.623.
• For the following period, 1989–2007, the annual correlation actually fell slightly to 0.614.

We can also examine the correlation data for international small-caps. Historically, international small-cap stocks have had lower correlation to U.S. stocks, making them superior diversifiers of the risks of domestic equities.

• For the first period, 1970–88, the annual correlation of the S&P 500 Index to international small-cap stocks was just 0.459—significantly lower than the 0.623 correlation of the MSCI EAFE for the same period.
• For the following period, 1989–2007, the annual correlation actually fell to 0.374—again, significantly lower than the 0.614 of the MSCI EAFE Index for the same period (from Dimensional Fund Advisors International Small Cap Index)

As you can clearly see, there is no trend toward rising correlations. Apparently the benefits of global diversification are as strong as ever.

Given the data, what explains all the noise about a new paradigm where the benefits of global diversification have disappeared? The answer can be explained in one simple word—recency. Recency is the tendency to give too much weight to recent experience, while ignoring the lessons of long-term historical evidence. Before getting into the most recent data we need to cover two important points.

The first important point is that correlations are not static. They tend to drift in a random manner. For investors, what should matter is the long-term historical evidence. And the longer the time frame, the more confident we can be about the data. Sometimes events occur that impacts both domestic and international equity markets in very similar ways. This is particularly true during periods of crisis like 1973–74 and 2000–02. Then there are other periods when equity markets perform quite differently.

The second important point is that because equity markets do experience periods of high correlation, investors need to hold a sufficient amount of high-quality fixed income assets to keep the risk of the overall portfolio at a level that is consistent with their ability, willingness and need to take risk. This is the most important of the asset allocation decisions.

Recent Data Driving Expectations

We have just experienced a relatively short period of very high correlation of U.S. and international stocks. For the five-year period from 2003 through 2007 the annual correlation of the S&P 500 Index to the MSCI EAFE Index rose to 0.991. So we have a lot of noise from the press and Wall Street about rising correlations. However, this is a very short period. And we have seen similar episodes of very high correlations. For example, for the five-year period from 1972 through 1976 the annual correlation of the S&P 500 Index to the MSCI EAFE Index rose to 0.874. That period probably produced similar cries about how global diversification was no longer needed. However, over the following five years the annual correlation fell all the way to 0.258.

Unfortunately, we cannot know what the next five years will bring—we don’t have clear crystal balls. However, there is nothing new in the data to suggest that over the long term the benefits of international diversification are any lower than they have been.

Lessons Learned

There are two important lessons to be learned from the above data. The first is that you should be very skeptical of cries that “this time it’s different.” To paraphrase Harry Truman: “There is nothing new in the world of investing except the investment history you do not know.” The second is that you should ignore the noise of the market. Noise sells. It sells for two reasons. First, the media needs you to tune in so they can make profits. Second, Wall Street needs you to believe that you should pay them big fees to manage assets in these “changing times.” Unfortunately, what is in the best interests of the financial media and Wall Street is often not in the best interests of investors.

Finally, consider this: Let us suppose that for whatever reason global equity markets do in fact become more closely correlated. Would that make global diversification unappealing? It is hard to see why that would be the case. Would it make sense for U.S. citizens to restrict their ownership of auto industry stocks to Ford and GM and eliminate firms such as Toyota or Porsche from consideration?

Summary

The bottom line is that international diversification is as important as ever. In fact, it has been said that diversification is the closest thing there is to a free lunch—so you might as well eat a lot of it. And, remember that the greatest diversification benefits are still in international small-cap stocks (and also emerging market stocks).

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.

Comments

[LBill]

Since diversifying between domestic and foreign stocks presently doesn't offer much diversification "bang for the buck," not much in total portfolio risk-adjusted return is likely to be lost for awhile by being under-diversified globally so it seems of minor importance at least for a time. Why not look for better ways to diversify until global equity market correlations actually do become smaller? If you had diversified into foreign stocks 10-15 years ago, when they were not as highly correlated with the U.S. market and were not performing as well, that would have paid off handsomely. Might be OK to do now if it helps you sleep better, but I wouldn't count on as big a payoff as waiting until global markets de-synchronize a bit.