Risks and Returns from Global Diversification
August 27, 2002
New research sheds light on the benefits of diversifying investment portfolios globally. Diversification lowers the risk that all of one's investments will decline in value at the same time, and it increases the likelihood that some of one's holdings will rise. According to a recent working paper published by the Yale International Center for Finance, an important factor has been overlooked in diversification: the expanding set of investment opportunities from the increase in investable markets worldwide.
In order to analyze the benefits of diversification over time, the authors collected all available data from the past 150 years. Among their conclusions:
- The more integrated markets are between countries, the more likely they are to move in tandem (that is, the more highly correlated they are), and thus the lower the benefits of diversification.
- However, the number of stock markets rose from four in the mid-19th century to 50 in 2000, so there are broader opportunities for diversification.
- Emerging markets increase the benefits of diversification because they are less correlated with markets in developed countries and offer additional investment opportunities.
Economic integration in the last decades of the 20th century led to highly correlated markets, diminishing the benefits of global diversification. But market liberalization in developing countries increased investment opportunities. Both aspects of globalization should be considered in assessing the benefits of diversification, say the authors.
Source: "The Dual Benefits of Global Diversification," Economic Intuition, Fall 2001; based on William N. Goetzmann, Lingfeng Li and K. Geert Rouwenhorst, "Long-Term Global Market Correlations," Working Paper No. 00-60, Yale International Center for Finance.
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