As the director of research for the BAM Alliance, I was recently asked to comment on columnist Mark Hulbert’s article “International stocks provide the least protection just when investors need it most.”
Hulbert noted: “U.S. stocks’ performance so far this year offers a perfect illustration of why investors should not exaggerate the benefits of international diversification. When the U.S. stock market plunged more than 10% in late January and early February, for example, international stocks lost even more. Far from cushioning the fall for investors, they made things slightly worse. When the U.S. stock market again fell sharply, between Mar. 9 and Apr. 2, international stocks also fell. Though this time they didn’t fall as much as U.S. equities, the cushion they did provide was scant comfort.”
He concluded: “In both cases, international diversification did not live up to its advance billing as providing a ‘free lunch’ of reducing portfolio volatility while forfeiting very little return in the process.”
To be fair, he did add: “These two instances by themselves add up to little more than anecdotal evidence. But it turns out that, historically, what happened in these cases is more the rule than the exception. What then accounts for the ‘free lunch’ narrative that is widely associated with international diversification? Because, on paper, such diversification is supposed to work a lot better: Even though international stocks exhibit relatively little correlation with domestic stocks, their return over the long term is quite similar. A portfolio divided equally between domestic and international stocks should therefore produce the same return as a domestic-only portfolio but with significantly less volatility.”
Hulbert went on to explain: “The problem is that the correlation between domestic and international stocks is not constant. It instead shifts with the bull and bear cycle of the market itself: The correlation is lowest when the U.S. market is rising, and highest when U.S. equities are falling. As a result, international stocks provide the least diversification precisely when investors need it most—when U.S. stocks are declining. And when U.S. stocks are rising, and investors don’t need or want any diversification, international stocks provide it in spades.”
Where Hulbert Goes Wrong
While diversification has been rightly called the only free lunch in investing—a portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country held in isolation—the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose towards 1. Many investors, and apparently Hulbert, took away the wrong lesson from what happened—that global diversification doesn’t work because it fails when its benefits are needed most. This is wrong on two fronts.
First, the most critical of lessons that should have been learned is that because correlations of risky assets tend to rise toward 1 during systemic global crises, the most important diversification is to ensure your portfolio has a sufficiently high allocation to the safest bond investments so that your overall portfolio’s risk is dampened to the level appropriate to your ability, willingness and need to take risk.
The reason is that, during systemic financial crises, the correlations of the safest bonds to stocks—while averaging about zero over the long term—tend to turn sharply negative when needed most, as they benefit from not only flights to safety but from flights to liquidity.
The other wrong lesson investors took away, and what Hulbert missed in his article, is that they failed to understand that, while international diversification doesn’t work necessarily in the short term, it does work eventually.
This point was the focus of a paper by Clifford Asness, Roni Israelov and John Liew, “International Diversification Works (Eventually),” which appeared in the May/June 2011 edition of the Financial Analysts Journal.
They explain that those who focus on the fact that globally diversified portfolios don’t protect investors from short systematic crashes miss the greater point that investors whose planning horizon is long term (and it should be, or you shouldn’t be invested in stocks to begin with) should care more about long-drawn-out bear markets, which can be significantly more damaging to their wealth.
Risk Aversion’s Brief Shelf Life
In their study, which covered the period 1950–2008 and 22 developed-market countries, the authors examined the benefit of diversification over long-term holding periods. They found that, over the long run, markets don’t exhibit the same tendency to suffer or crash together. Thus, investors shouldn’t allow short-term failures to blind them to long-term benefits.
To demonstrate this point, they decomposed returns into two pieces: (1) a component due to multiple expansion (or contraction); and (2) a component due to economic performance. They found that, while short-term stock returns tend to be dominated by (1), long-term stock returns tend to be dominated by (2). They explained that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns.”
They further showed that “countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns.”
For example, in terms of worst-case performances, they found that, at a one-month holding period, there is very little difference in performance between home-country portfolios and global portfolios. However, as the horizon lengthens, the gap widens—the worst cases for the global portfolios are significantly better (the losses are much smaller) than the worst cases for the local portfolios. And the longer the horizon, the wider the gap favoring the global portfolios.
Demonstrating the point that long-term returns are more about a country’s economic performance, and that long-term economic performance is quite variable across countries, they found that “country specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time.”
The conclusion drawn by Asness, Israelov and Liew—and the one you should draw—is that, while global diversification can disappoint over the short term, over the long term, which is far more relevant, “it is the free (and hearty!) lunch that theory and common sense says it should be.”
If you need a specific example of the wisdom of this advice, look to Japan. Clearly, Japanese investors have benefited from global diversification. The poor returns Japan experienced since 1990 weren’t a result of systemic global risks. They happened because of Japan’s idiosyncratic problems.
And before you make the mistake of confusing the familiar with the safe, you cannot know which country or countries will experience a prolonged period of underperformance. And that uncertainty is what international diversification protects you against. Their insights won for the authors the CFA Institute’s prestigious Graham and Dodd Award for the best paper of the year.
Larry Swedroe is the director of research for The BAM Alliance.
This commentary originally appeared October 24 2018 on ETF.com.
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