Does it make sense to diversify your asset portfolio internationally?

Financial economists say one of  the golden rules for building a sound portfolio is to diversify your holdings. So one could  diversify portfolio across asset classes (bonds vs equities), across similar assets (within equities different companies in different sectors) and regionally (domestic vs international).

The recent crisis has poked a lot of holes in economic theory. If not holes then has certainly questioned many things in the crisis.

Karen Lewis a fellow at Dallas Fed says US investors need to rethink on global diversification of portfolio. The main idea behind global diversity is shares of foreign companies will move differently from US companies. So if US companies do badly, international companies can save the portfolio and vice-versa. This helps lower volatility of portfolio as well.

However, Lewis points the diversity not helping after 2001:

Even with U.S. investors’ increased ability to diversify with foreign stocks, how have these shares fared during the recent financial events?

Because the benefits to diversification depend on how tightly foreign and domestic stocks move together, we start by examining this comovement over time.[3] Interestingly, we find that foreign stocks provide a better hedge against the U.S. market before they begin trading on U.S. exchanges. Once that occurs, they move more closely with the American market. This behavior is consistent with the view that more Americans hold these foreign stocks, thereby inheriting similar risk factors.

We then study the behavior of an index of these foreign stocks on the NYSE and Nasdaq together with the U.S. market index. We ask how much risk within the U.S. portfolio could be reduced by holding these foreign stocks.

Chart 4A shows the holdings for foreign securities that would yield the lowest variance in each year. In the early 1970s through the 1990s, the lowest volatility would generally have been obtained with a relatively high proportion of 50 percent or more in foreign stocks. However, after the market decline in 2001, this relationship changed sharply. To get the lowest volatility in equity markets, the proportion in the foreign stocks would be negative. That is, an American investor would have to bet against the foreign market by selling these securities, commonly called “short selling.” Since short sales are difficult for small investors, the lowest practical volatility strategy would have been to hold no foreign stocks.

So it makes better sense to short-sell foreign stocks rather than hold them in your portfolio.

The summary is:

In general, foreign stocks should provide diversification potential because they are influenced more strongly by events in their own markets. However, equity returns from foreign companies listed on American exchanges move much more closely with U.S. market returns. As such, they lose their diversification potential. Moreover, when global markets are affected by common sources of risk, such as the European debt crisis, these comovements are exacerbated. In these times, the foreign diversification potential is indeed diminishing.

This is just a US example but think would apply to most countries. In India for example, barring some recent months Indian stock markets have tracked global movements much closely. So one could just see how US and Europe markets closed previous day to determine the movement in Indian markets today. The relationship was as simple as that. The correlation was almost 1. There was little difference whether an Indian investor traded in NSE or Nasdaq as  broadly the returns were more or less  similar…

In this globalised world, financial markets have become far more integrated and globalizsed than other parameters. It is amazing to see the kind of global data the domestic analysts and traders track and how quickly a change in some German data/policy impacts the sentiments in India. So I don’t think this is going to be limited to the crisis alone.





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