Recent Data Driving Expectations

We have just experienced a relatively short period of very high correlation of U.S. and international stocks. For the five-year period from 2003 through 2007, the annual correlation of the S&P 500 Index to the MSCI EAFE Index rose to 0.991. So we have a lot of noise from the press and Wall Street about rising correlations. However, this is a very short period. And we have seen similar episodes of very high correlations. For example, for the five-year period from 1972 through 1976, the annual correlation of the S&P 500 Index to the MSCI EAFE Index rose to 0.874. That period probably produced similar cries about how global diversification was no longer needed. However, over the following five years, the annual correlation fell all the way to 0.258.

Unfortunately, we cannot know what the next five years will bring-we don't have clear crystal balls. However, there is nothing new in the data to suggest that over the long term the benefits of international diversification are any lower than they have been.

Lessons Learned                     

There are two important lessons to be learned from the above data. The first is that you should be very skeptical of cries that "this time it's different." To paraphrase Harry Truman: "There is nothing new in the world of investing except the investment history you do not know." The second is that you should ignore the noise of the market. Noise sells. It sells for two reasons. First, the media needs you to tune in so they can make profits. Second, Wall Street needs you to believe that you should pay them big fees to manage assets in these "changing times." Unfortunately, what is in the best interests of the financial media and Wall Street is often not in the best interests of investors.

Finally, consider this: Let us suppose that for whatever reason, global equity markets do in fact become more closely correlated. Would that make global diversification unappealing? It is hard to see why that would be the case. Would it make sense for U.S. citizens to restrict their ownership of auto industry stocks to Ford and GM, and eliminate firms such as Toyota or Porsche from consideration?

Summary

The bottom line is that international diversification is as important as ever. In fact, it has been said that diversification is the closest thing there is to a free lunch-so you might as well eat a lot of it. And, remember that the greatest diversification benefits are still in international small-cap stocks (and also emerging market stocks).

¹Dimensional Fund Advisors International Small Cap Index

His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.

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