International Diversification Works (Eventually)

Critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns. Although true, this observation misses the big picture. Over longer horizons, underlying economic growth matters more than short-lived panics with respect to returns, and international diversification does an excellent job of protecting investors.Investors and financial economists have long debated the benefits of global equity market diversification. Fans have argued that diversifying globally reduces portfolio risk without harming long-term returns. Some critics have countered that because markets become more correlated during downturns, most of the diversification occurs on the upside, when it is not needed, and vanishes on the downside, when it is needed most. A related and perhaps more distressing observation is simply that markets tend to crash at the same time.In our study, we argued that those who dismiss diversification on the basis of these critiques miss the bigger point. Long-term investors with planning horizons measured in decades should not devote a great deal of anxiety to the risk of common, short-term crashes. A much greater concern is a long, drawn-out bear market, which can be significantly more damaging to investors’ wealth.Going back to 1950, we examined the benefits of diversification over long-term holding periods by examining the real returns of 22 countries. We found evidence that the observed co-skewness of markets is a short-term phenomenon. Over the long run, markets do not tend to crash together.To understand the difference between the short- and long-term benefits of diversification, we decomposed returns into two pieces: (1) a component arising from multiple expansion and (2) a component arising from economic performance. We found that short-term stock returns tend to be dominated by multiple expansion, which is consistent with the idea that a sharp, systemic decline in investors’ appetite for risk can explain why markets crash at the same time. Over the long term, however, economic performance drives returns. We showed that countries exhibit significant idiosyncratic variation in long-run economic performance. Hence, country-specific (not global) long-run economic performance is the most important determinant of long-run returns.At times, short-term investors may be justifiably disappointed by international diversification, which does little to protect against systemic global panics. International diversification, however, successfully protects long-term investors from being overexposed to a country that has a lost decade (or two). We should not allow investors’ short-term disappointment to dissuade us from realizing the long-term benefits of international diversification.