A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

THE 
BENEFITS 
OF
DIVERSIFICATION

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Those with a broader view—investors who recognize that
the world has changed considerably since Markowitz first
enunciated his theory—can reap even greater protection
because the movement of foreign economies is not always
synchronous with that of the U.S. economy, especially those
in emerging markets. For example, increases in the price of oil
and raw materials have a negative effect on Europe, Japan,

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and even the United States, which is at least partially self-
sufficient. On the other hand, oil price increases have a very
positive effect on Indonesia, and oil-producing countries in
the Middle East. Similarly, increases in mineral and other
raw-material prices have positive effects on nations rich in
natural resources such as Australia and Brazil.
It turns out that about fifty is also the golden number for
global-minded investors. Such investors, however, get more
protection for their money, as shown in the preceding chart.
Here, the stocks are drawn not simply from the U.S. stock
market but from the international markets as well. As
expected, the international diversified portfolio tends to be
less risky than the one drawn purely from U.S. stocks.
The benefits of international diversification have been well
documented. 
The 
figure 
Diversification of U.S. and
Developed Foreign Country Stocks, January 1970–December
2009
shows the gains realized over the forty-year period
from 1970 through 2009. During this time period, foreign
stocks (as measured by the Morgan Stanley EAFE [Europe,
Australasia, and Far East] Index of developed foreign
countries) had an average annual return that was slightly
higher than the U.S. stocks in the S&P 500 Index. U.S.

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stocks, however, were safer in that their year-to-year returns
were less volatile. The correlation between the returns from
the two indexes during this time period was around 0.5—
positive but only moderately high. The figure shows the
different combinations of return and risk (volatility) that
could have been achieved if an investor had held different
combinations of U.S. and EAFE (developed foreign country)
stocks. At the right-hand side of the figure, we see the higher
return and higher risk level (greater volatility) that would have
been achieved with a portfolio of only EAFE stocks. At the
left-hand side of the figure, the return and risk level of a
totally domestic portfolio of U.S. stocks are shown. The
solid dark line indicates the different combinations of return
and volatility that would result from different portfolio
allocations between domestic and foreign stocks.
Note that as the portfolio shifts from a 100 percent
domestic allocation to one with gradual additions of foreign
stocks, the return tends to increase because EAFE stocks
produced a slightly higher return than domestic stocks over
this period. The significant point, however, is that adding
some of these riskier securities actually reduces the
portfolio’s risk level—at least for a while. Eventually,

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however, as larger and larger proportions of the riskier EAFE
stocks are put into the portfolio, the overall risk rises with
the overall return.