The Foreign Diversification Myth?

It's become something of a mantra among U.S. investors: diversify overseas to boost returns and protect assets.

In recent years, investing in foreign markets has been widely seen as a way to counter the risks associated with investing at home. These risks include the fallout from America's ongoing fiscal woes, the restructuring of an overly consumer-dependent economy, and a relentless long-term decline in the value of the dollar.

Proponents also argue that it is the only way to capitalize on "the leveling of the global economic playing field," as lesser-developed countries around the world, including high-flyers like China, India, and Brazil, play catch-up with the likes of America and Western Europe.

The truth is, however, that U.S. and overseas markets have become tightly-linked, at least from the point of view of dollar-based investors. While there was a time when share prices here and elsewhere moved to their own tunes, that no longer seems to be the case.

In fact, based on an analysis of data going back several decades, the correlation between monthly returns for the S&P 500 index and a broad global benchmark, the MSCI World Ex-US index, has never been greater. More surprising to some, perhaps, is the fact that emerging market returns have also become increasingly correlated to those of the U.S.

Why has this happened? The most likely reasons include the effects of increasing globalization, rising cross-border capital flows, the growing influence of large-scale multinational corporations, greater use of offshoring and outsourcing, and the information-spreading power of global media firms and the internet.

Will things remain that way? In the long-run, most likely not. As those who have read my books and blogs know, I believe America's role in the world will eventually change for the worse. However, for the time being, at least, those who think they are protecting themselves by investing in foreign stocks may not realize the benefits they were hoping for.

Comments

[Plan B Economics]

Are you calculating MSCI returns in local currency or USD?

[Michael Panzner]

US dollars, so it is comparing like with like.

[Tick]

Very interesting. These two indexes being very weighted on larger companies, I would still have expected the more rapid economic growth rates in foreign countries to push the gap wider. Any breakdown on how much of this is due to the European companies, vs those in the "high flyer" economies? Also, it might be interesting to see how the Russell 2000 compares, although I don't know what would be the appropriate foreign index to compare it to.

[Bill Hartman]

Unless I am seriously mistaken, if a foreign stock market rises exactly $2 for every rise of $1 in the US markets, and falls $2 for every fall of $1 in the US, then the correlation would be 1.0. In other words, investing in foreign markets could give the effect of greater leverage, even if the correlation is very high.