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.)

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.)

Related Articles
  1. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  2. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  3. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  4. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  5. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  6. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  7. Investing Basics

    Diversifying Your Portfolio: 5 Easy Steps

    You can never be sure of what the market will do at any given moment. That’s why a well-diversified portfolio is so important.
  8. Mutual Funds & ETFs

    Top 4 Investment Grade Corporate Bonds ETFs

    Discover detailed analysis and information about some of the top exchange-traded funds (ETFs) that offer exposure to the investment-grade corporate bond market.
  9. Retirement

    Should Balanced Funds Be Part Of Your Portfolio?

    Find out why you should include balanced funds in your portfolio, including the importance of customizability, diversification and professional management.
  10. Investing Basics

    6 Investing Mistakes That the Ultra Wealthy Don't Make

    Understand what ultra-high-net-worth individuals are and how they invest. Learn about the six key investment mistakes that the ultra wealthy avoid.
  1. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  2. When are mutual funds considered a bad investment?

    Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>
  3. What fees do financial advisors charge?

    Financial advisors who operate as fee-only planners charge a percentage, usually 1 to 2%, of a client's net assets. For a ... Read Full Answer >>
  4. Can your car insurance company check your driving record?

    While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
  5. Can mutual funds invest in private equity?

    Mutual funds can invest in private equity indirectly by buying shares of publicly listed private equity companies, such as ... Read Full Answer >>
  6. Can mutual funds invest in MLPs?

    Mutual funds invest in a wide variety of securities, including master limited partnerships, or MLPs. Because MLPs exhibit ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!