Stocks for the Long Run : the Definitive Guide to Financial Market Returns and Long-term Investment Strategies

(Greg DeLong) #1

DIVERSIFICATION IN WORLD MARKETS


Principles of Diversification


It might surprise investors that the principal motivation for investing in
foreign stocks is not that foreign countries are growing faster and there-
fore will provide investors with better returns. We learned in Chapter 8
that faster growth in no way guarantees superior returns.
Rather, the reason for investing internationally is to diversify your
portfolio and reduce risk.^5 Foreign investing provides diversification in
the same way that investing in different sectors of the domestic economy
provides diversification. It would not be good investment policy to pin
your hopes on just one stock or one sector of the economy. Similarly it is
not a good policy to buy the stocks only in your own country, especially
when developed economies are becoming an ever smaller part of the
world’s market.
International diversification reduces risk because the stock prices
of one country often rise at the same time those of another country fall,
and this asynchronous movement of returns dampens the volatility of
the portfolio. However, in recent years, world markets have moved
more in sync with each other, particularly in the short run, which I will
discuss later in this chapter.
An asset with a low correlation with the rest of the market provides
better diversification than an asset with a high correlation. The correla-
tion of returns between stocks or portfolios of stocks is measured by the
correlation coefficient.A good case for investors is if there is no correlation
between the stock returns of two countries, and the correlation coeffi-
cient is equal to zero. In this case, an investor who allocates his or her
portfolio equally between each country can reduce his or her risk by al-
most one-third, compared to investing in a single country. As the corre-
lation coefficient increases, the gains from diversification dwindle, and if
there is perfect synchronization of returns, the correlation coefficient
equals 1 and there is no gain (but no loss) from diversification.


“Efficient” Portfolios: Formal Analysis


How do you determine how much should be invested at home and
abroad? As the above analysis suggests, the amount invested in each
country can be derived from one’s assessment of the expected risk and


168 PART 2 Valuation, Style Investing, and Global Markets


(^5) Riskhere is defined as the standard deviation of the returns on the portfolio.

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