Avoid this mistake about global diversification

Don't get stuck in your own backyard. Investors should consider building globally diversified equity portfolios that avoid the persistent and worldwide phenomenon of home-country bias. That's when you allocate a greater weight to your home-country stocks than their percentage of total global market capitalization.

Among the reasons investors around the world exhibit this bias is that they confuse the familiar with the safe. Unfortunately, Lake Wobegon -- home of the perennially above-average -- exists only in fiction. It cannot be that every developed country is safer than the others.

Compounding the problem is that investors tend to believe not only that their home country is a safer place to invest, but also that their home country will produce higher returns. This belief defies the basic financial concept that risk and expected return are related.

While diversification rightly has been called the only free lunch in investing -- a portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country held in isolation -- the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose toward one (meaning essentially that investors had nowhere to hide).

Many investors took the wrong lesson from what happened and concluded that global diversification doesn't work because it fails when its benefits are needed most. This view is a mistake on two fronts.

First, the most critical lesson to learn from 2008 is that -- because correlations among risky assets tend to rise toward one during systemic global crises -- the most important diversification to achieve is ensuring your portfolio has a sufficiently high allocation of the safest bond investments.

This will dampen your portfolio's overall risk to the level appropriate for your personal ability, willingness and need to take risk.

During systemic financial crises, the correlation of the safest bonds to stocks, while averaging about zero over the long term, tends to turn sharply negative when it's needed the most because bonds benefit not only from flights to safety but also from flights to liquidity.

Second, investors fail to understand that while international diversification doesn't necessarily work in the short term, it does work if you give it enough time. This point was the focus of a paper titled "International Diversification Works (Eventually)" by Clifford S. Asness, Roni Israelov and John M. Liew that appeared back in the May and June 2011 edition of Financial Analysts Journal.

They explain that those who focus on the fact that globally diversified portfolios don't protect investors from short systematic crashes miss the greater point. Instead, investors whose planning horizon is long-term (and it should be, or you shouldn't be invested in stocks to begin with) should care more about long, drawn-out bear markets, which can be significantly more damaging to their wealth.

In their study, which covered the period from 1950-2008 and included 22 developed market countries, the authors examined the benefits of diversification over long-term holding periods. They found that over the long run, markets don't exhibit the same tendency to suffer or crash together. Thus, investors shouldn't allow short-term failures to blind them to long-term benefits.

To demonstrate this point, they divided returns into two pieces: (1) a component due to multiple expansion, or contraction, and (2) a component due to economic performance. They found that short-term stock returns tend to be dominated by the multiple expansion component, and long-term stock returns tend to be dominated by the economic performance component.

The authors explain that these results "are consistent with the idea that a sharp decrease in investors' risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk-aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns."

They further show that "countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns."

For example, in terms of worst-case performances, the study found that in a one-month holding period there was very little difference in returns between home-country portfolios and the global portfolio. However, as the horizon lengthens, the gap widens. The worst-case performances for the global portfolio are significantly better (meaning the losses are much smaller) than the worst-case performances for the local portfolio.

Demonstrating both that long-term returns tend to be about a country's economic performance and that long-term economic performance is quite variable across countries, the authors write that "country specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time."

The authors concluded that while global diversification can disappoint over the short-term, over the far more relevant long-term, diversification "is the free (and hearty!) lunch that theory and common sense says it should be."

If you need a specific example of the wisdom of this advice, look to Japan. The poor returns Japan has experienced since 1990 aren't the result of systemic global risks. They're the result of Japan's idiosyncratic problems.

Before you make the mistake of confusing the familiar with the safe, remember that you cannot know which country or countries will experience a prolonged period of underperformance. And that uncertainty is what international diversification protects you against.