When geographic diversification fails to give your portfolio the safety net you were hoping for, how do you create a portfolio that still provides security so that all your holdings do not rise or fall in unison? This is not an easy feat and with many investors facing growing liabilities, and it is no wonder they are up in arms about how to obtain a higher alpha at a reduced risk. The superior risk-adjusted returns attained though geographically diversifying a portfolio seem to be harder to come by. As Thomas Friedman discusses in his book "The World is Flat" (2005), it appears the globalization of the world's economies has increasingly been rendering the notion of geographic diversification as a risk reducer null and void. But is this really the case?

The argument that the creation of the world-wide web has shrunk the world may or may not play out to be true in the returns of the stock market. The correlation of returns for the S&P 500, as a proxy for the U.S. economy, and the MSCI World ex US, as a proxy for the international markets, should be a tell tale sign about the validity of geographic diversification as a way to reduce risk in a portfolio. If this correlation is high, what other avenues can investors explore to bring about more stability in portfolio returns? (Historically, international investing has worked out well for investors, but this may no longer be the case. For further reading, see Does International Investing Really Offer Diversification?)

The U.S. and International Markets
Financial planners have unswervingly made the plausible argument that the best way to reduce risk in a portfolio is to diversify, and one of the easiest ways to diversify in a stock portfolio is to invest in different geographies. The notion existed that each country's economy, while interacting with others on the periphery is based on local business and politics and it therefore experiences independent success or failure. However, historically we have instances when this thinking failed, such as the Asian Crisis in 1997, the crash on Black Monday in 1987 or most famously the Great Depression in the late 1920s to early 1930s.

More recently, the Great Recession also saw an international slowdown in the world's financial sector as equity prices across all borders suffered. Keeping these events in isolation and thinking them anomalies has led to the continual argument for geographic diversification as a risk reducer. Yet the widespread use of the internet has shrunk the world and created more of a global marketplace rather than country specific markets. So the question begs: Does geographic diversification still provide the necessary dispersion of returns needed to reduce risk?

The proceeding graph exams the returns of the S&P 500 (U.S. proxy) and the MSCI World ex US (international proxy) indexes, providing insight on this question.

Figure 1: U.S. Vs. International
Source: Merril Lynch Advisory Services Group Monitor April 2010

As you can see, the returns for the S&P 500 and the MSCI World ex US have a high correlation. Some may argue that the time frame is not long enough, but the introduction and adoption of the internet has acted as a catalyst creating economic opportunities in countries once sheltered by geographic barriers. Thus this time frame seems the most suitable proxy for the future. The graph clearly shows that geographic diversification fails, so what other ways can investors diversify risk?

Alternate Diversification Strategies
Geographic diversification is not the only strategy available to reduce risk in a portfolio. Different investment styles, like small cap vs. large cap investing or employing a growth strategy vs. a value strategy, may provide further portfolio risk reduction. But there are pros and cons to both of these options.

Figure 2: Capitalization
Source: Merril Lynch Advisory Services Group Monitor April 2010

Although between 2005-2009 the returns follow the same pattern, prior to that, specifically from 1998-2002, there is a large difference in the return pattern. Exemplifying this is 2001, when the S&P 500 (large caps) was down almost 12% while the S&P 600 (small caps) was up over 6%. Because companies of different sizes tend to have different performance depending on the economic environment, a mix of strategies should help in the diversification process. However, when major financial meltdowns such as that witnessed through 2007-2009 occur, the effects of the strategy are limited.

Figure 3: Growth Vs. Value
Source: Merril Lynch Advisory Services Group Monitor April 2010

The returns of growth and value stocks are by far the most dissimilar of the examples shown, a good sign for diversifying away portfolio risk. This finding, though, is not without its naysayers. Some argue that achieving a growth or value portfolio is very difficult over time because many of the stocks that make up these portfolios move from being growth stocks to value and vice versa resulting in a difficult to achieve strategy.

Figure 4: Stocks Vs. Bonds
Source: Merril Lynch Advisory Services Group Monitor April 2010

The theory that stocks and bonds act in opposite ways is proven in most years as exemplified in the above graph. Diversifying risk by investing in different types of securities seems to be the most plausible avenue to follow. By following this type of strategy, a portfolio will achieve risk reduction. However along with reduced risk, there is also a muting effect on returns. In other words, by employing this strategy, investors buy some protection but also reduce the upside potential.

The above mentioned strategies are not the only ones available to investors who seek diversification. Reducing stock specific risk can be achieved by investing in various sectors, especially ones which have very different characteristics such as utilities and technology, or utilizing derivatives such as options to hedge risk. (Without this risk-reduction technique, your chance of loss will be unnecessarily high. To learn more, read The Importance Of Diversification.)

Conclusion
Portfolio risk is one of the biggest drawbacks for investors and finding a way to reduce that risk is of highest priority. This type of strategy may not provide the best returns in any one year, but it has never provided the worst. So when investors wish to diversify, and geographic diversification fails, making use of other strategies, such as investing in an array of capitalizations, styles or securities, should pay off in the long term. (For more educational material on diversification, check out 5 Tips For Diversifying Your Portfolio.)

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