This is why you need to diversify globally – which is probably not why you think

Diversification is a centrepiece of portfolio construction. If you don’t spread risk around, by grouping together assets that are not correlated, you’re putting all your eggs in the same basket.

According to personal finance textbooks – and most financial planners – geographical diversification, or investing in different markets around the world, is one of the easiest ways to diversify.

But it’s time to re-write the textbooks. Geographical diversification doesn’t work like it used to. In fact, for some markets, it hardly works at all.

Correlation is the relationship or connection between two or more assets. It measures what generally happens to Asset A when Asset B’s price changes, although there’s no direct causation necessarily implied.

A correlation of 1.0 means that when one asset goes up, the other asset goes up. A measure of -1.0 means two assets are perfectly negatively correlated. So when one asset goes up, the other goes down. And a correlation of zero means the two assets move independent of one another.

The point of diversification is to ensure that you have different types of assets in your portfolio that aren’t correlated. For example, gold isn’t correlated with much. And real estate generally doesn’t move in step with stock markets.

It used to be that investing in different parts of the world was a good way to diversify. Markets on the other side of the world moved to the yells of very different noisy traders, and had little to do with each other.

From 1990-1995, for example, the correlation between the S&P 500 and Singapore’s STI was just 0.1, or almost no correlation at all.

The S&P 500 and the Shanghai Composite (SHCOMP) – which would have been called a frontier market had the terminology existed – was just 0.03. The correlation between the U.S. S&P 500 and the U.K. FTSE, at 0.32, was higher.

But that’s all changed. As shown below, those correlations have been steadily creeping up over the past 25 years. Over the past five years, the correlations for markets across the board have risen sharply. For example, the correlation between the S&P 500 and the STI now stands at 0.3; and with the Shanghai Composite, 0.29.

S&P 500 correlation with other markets

Correlations between markets within Asia have been rising over time as well. The graph below shows correlations between the Shanghai Composite and the STI, the Hang Seng, the FTSE, and MSCI Asia ex-Japan.

For example, 20 years ago, the correlation between Hong Kong’s Hang Seng Index (HSI) and the Shanghai Composite was only 0.01, which means they moved completely independently. Now it’s nearly 0.5. The STI had a correlation with the Shanghai Composite around zero, but now it’s over 0.3. Even Japan’s stock market, which has barely moved over the past 20 or so years, has seen its correlation with the Chinese market rise to over 0.2.

Shanghai Composite correlation with other markets

Why have these correlations been rising? Blame globalisation. Linkages between economies, and markets, have been rising over time. What happens in one economy matters a lot more to others than it used to. Also, listed companies are increasingly global in their business, so their fortunes are tied to economies other than the market where their stock is traded.

The value of market diversification – from the perspective of correlation – has decreased over time. But this doesn’t mean that you shouldn’t bother with investing in markets outside your home market. As shown below, even though the correlation between markets is higher, the returns of different markets can differ widely.

25-year period average annual returns

And that’s why it still pays to invest in other countries. The value of geographical diversification has fallen in terms of correlation – but not in terms of returns. Diversifying geographically is now more about improving your returns than spreading out risk.

The easiest, most effective way to invest outside your home country is using an exchange traded fund (ETF). For instance, you can invest in the U.S. through the Vanguard S&P 500 Index ETF (code: 3140, Hong Kong), or the Lyxor Dow Jones Industrial Average ETF (code: JC6, Singapore). Another option is to just buy the Lyxor UCITS ETF MSCI World (code: H1P, Singapore), this gives you exposure to the biggest companies in the world with one share.

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