Global Diversification

Abstract

Correlations between the returns of U.S. stocks and international stocks were higher recently than in the past, reaching 0.86 during the 60 months ending in December 2003. Today's investors note the high correlations between U.S. and international stocks and doubt the benefits of global diversification.

We argue that the benefits of global diversification remain high and that the correlation between U.S. and international stocks is a misleading measure of the benefits of global diversification. This is for two reasons. First, the benefits of global diversification depend not only on the correlation between the returns of U.S. and international stocks but also on the standard deviations of these returns. Second, we tend to have poor intuition about the link between correlation and the benefits of diversification. A 0.86 correlation seems high enough to eliminate the benefits of diversification, but even correlations much higher than 0.86 are associated with substantial benefits. Dispersion of returns is a better measure of the benefits of diversification because it accounts for the effects of both correlation and standard deviation and because it provides an intuitive measure of the benefits of diversification. We present the relationship between correlation, standard deviation and dispersion.

Keywords: Diversification, behavioral portfolio theory, dispersion, correlation, global portfolios

JEL Classification: G11, G12