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

DIVERSIFICATION OF U.S. AND
DEVELOPED FOREIGN COUNTRY
STOCKS, 
JANUARY 
1970–
DECEMBER 2009

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Source: DATASTREAM.
The paradoxical result of this analysis is that overall

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portfolio risk is reduced by the addition of a small amount of
riskier foreign securities. Good returns from Japanese
automakers balanced out poor returns from domestic ones
when the Japanese share of the U.S. market increased. On the
other hand, good returns from U.S. manufacturers offset poor
returns from foreign manufacturers when the dollar became
more competitive and Japan and Europe remained in a
recession as the U.S. economy boomed. It is precisely these
offsetting movements that reduced the overall volatility of the
portfolio.
It turns out that the portfolio with the least risk had 17
percent foreign securities and 83 percent U.S. securities.
Moreover, adding 17 percent EAFE stocks to a domestic
portfolio also tended to increase the portfolio return.
International diversification provided the closest thing to a
free lunch available in our world securities markets. When
higher returns can be achieved with lower risk by adding
international stocks, no investor should fail to take notice.
Some portfolio managers have argued that diversification
has not continued to give the same degree of benefit as was
previously the case. Globalization led to an increase in the
correlation coefficients between the U.S. and foreign markets

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as well as between stocks and commodities. The following
three charts indicate how correlation coefficients have risen
over the first decade of the 2000s. The charts show the
correlation coefficients calculated over every twenty-four-
month period between U.S. stocks (as measured by the S&P
500-Stock Index) and the EAFE index of developed foreign
stocks, between U.S. stocks and the broad (MSCI) index of
emerging-market stocks, and between U.S. stocks and the
Goldman Sachs (GSCI) index of a basket of commodities such
as oil, metals, and the like. Particularly upsetting for investors
is that correlations have been particularly high when markets
have been falling. During the global credit crisis of 2007–09,
all markets fell in unison. There was apparently no place to
hide. Small wonder that some investors came to believe that
diversification no longer seemed to be an effective strategy to
decrease risk.