What is the proper time frame to judge the benefits of international diversification?

This question was raised in the midst of the financial crisis when the correlation of equity markets, any every other risky asset for that matter, approached unity.   It was clear at that time that many investors had fooled themselves as to the riskiness of their portfolios.  The credit crisis demonstrated the error of their ways.  Indeed some went so far as to wonder whether traditional asset allocation models are broken.

A recent paper by four professors at McGill University asks the question:  “Is the potential for international diversification disappearing?”  (For additional comments see Paul Kedrosky & FT Alphaville.)  In their paper they note the trend of increasing equity market correlations across both the developed and emerging markets.  In the case of emerging markets they note that the incidence of tail events in the emerging markets seem to be country-specific, whereas in the developed world negative environments seem to cross borders.

So if the benefits of international diversification are slowly disappearing, and in the case of crisis-like conditions, gone altogether what is it good for?  Another new paper seeks to answer this very question.  Asness, Israelov and Liew have a working paper up, “International diversification works (in the long run)” with the emphasis definitely being on the long term.

In it they acknowledge the many findings on rising international correlations in times of market stress.  Instead they focus on the benefits of international diversification over the long term.  Over that sort of time horizon international diversification serves as a insurance policy against the economic underperformance of your home market.  They argue that over this time horizon investors are best served by a globally diversified portfolio.

In the end there is no contradiction between these two papers.  They simply focus on two different time horizons.  This is a common problem in finance.  Lessons appropriate for one time horizon are misapplied (or misinterpreted) over another time horizon.  Indeed a great deal written about investing is better applied to more active investors as opposed to the majority who have long term investment goals.

Therefore those who argue that an all-domestic portfolio avoids the messy problem of international diversification miss the big picture.  Over some shorter time horizon this decision might very well turn out be a correct one.  Nor is international diversification some sort of panacea.  Investment risks abound both internationally (as well as domestically).  However over the long term ignoring the increasingly dynamic nature of the global economy and the benefits from diversifying across it seems short-sighted at best.

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