Diversification and Risk
December 7, 2001
Traditionally, international diversification has been the most effective way to reduce the risk of a stock portfolio. It has been superior to other strategies, such as diversification by industrial sector. However, globalization has reduced national barriers and affected investment strategies.
Nations are acting more and more in unison, while industries are becoming less and less coordinated, say researchers.
- The correlation between country-factor returns (the measure of how much countries are acting in unison) rose roughly 25 percent in 1994 to 60 percent by the end of 1999.
- Conversely, the volatility of returns by country has declined from 11.1 percent in the first half of the 1990s to 9.8 percent in the latter half.
- Over the same period, the volatility of industry returns has risen from 7.8 percent to 10.9 percent.
Other researchers have found that when it comes to stock returns "in the most recent four years, the importance of industrial sector classification was roughly equal to that of country of domicile in the major equity markets."
As globalization progresses, diversifying by country will become less and less effective at reducing risk, compared with diversifying by industry sector.
Source: "Diversify by Sector, Not by Country," Economic Intuition, Winter 2001; based on Michael Aked, Christopher Brightman and Stefano Cavaglia, "The Increasing Importance of Industry Factors," and Sean P. Baca, Brian L. Garbe and Richard A. Weiss, "The Rise of Sector Effect in Major Equity Markets," both Financial Analysts Journal, September/October 2000.
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