by Bernard R. Horn Jr.

In November 1983, I wrote an article for the AAII Journal about the benefits of international diversification. At that time, very few investors even considered international diversification as an investment option. In almost 30 years since that article was written the world has changed.

In 1983 there were about 23 developed investable markets; in 2010 there are nearly 100! Countries that were not part of the market economy (particularly Russia and China) are not only market economies, but are arguably drivers of the fortunes of many companies worldwide. Yet, during times of crisis, the benefits of global diversification are called into question. This article serves to address this concern.

The Rise and Fall of Correlations

Only in the world of finance do fundamental theories often fall into question when faced with disaster or crisis. Such was the situation during the 20072009 recession, when the correlation of equity markets appeared to approach parityand the benefits of diversification were called into question. The Wall Street Journal propagated this debate with a July 10, 2009, article by Tom Lauricella, Failure of a Fail-Safe Strategy Sends Investors Scrambling, which highlighted selected short-term correlation data points.

Correlation is computed as a correlation coefficient, which ranges from 1 to +1. Two random variables (e.g. security prices) are positively correlated if as one variable moves up or down, the other variable moves in lockstep directionally. They are negatively correlated if high values of one variable are associated with low values, or opposite movements, of the other. In portfolio management, finding investments that have low or negative correlation with each other offers the chance for better diversification.

Irrefutably, we have just witnessed a relatively brief period of high correlations between U.S. and international stocks. Using annual data for the five-year period from 2005 through 2009, the correlation of the S&P 500 index to the MSCI EAFE (Europe, Australasia, Far East) index rose as high as 0.99 during the time period. Quite a bit of noise ensued from the press and from Wall Street about the demise of diversification.

However, we have experienced similar short-term periods of very high correlations. For example, for the five-year period from 1972 through 1976 (based on calendar-year returns), the correlation of the S&P 500 index to the MSCI EAFE index rose to 0.87 (when the collapse of exchange-rate controls and an oil embargo coincided with a global stock price downturn). However, over the following five years (19771981), the correlation fell all the way to 0.25.

Clearly, correlations wax and wane considerably over myriad market cycles. Importantly, stocks worldwide tend to drop during periods of extreme market or economic stress (correlations move up), just as they did in the 19721976 period and in this recent crisis. But historically, U.S. and international returns have diverged shortly after the crisis ended (correlations moved down). This trend is evidenced in Table 1. which shows that correlations among the EAFE index and the S&P 500 during bear market cycles (20% or more drop) have been higher than they were during the bull market cycles that preceded them. Of the six bear markets from 1970 to 2009, five experienced an increase in correlation. Furthermore, all bear markets since 1982 have seen an increase in correlation. It is worth noting that the EAFE index does not include the many emerging markets that are now an important part of the global investment universe. This is a subject of further research at Polaris Capital.

So why the outcry negating the benefits of global diversification? 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, as defined by Larry E. Swedroe and Jared Kizer in The Only Guide to Alternative Investments Youll Ever Need (Bloomberg Press, 2008).