Diversification: High Dispersion Beats Low Correlation
When advisers talk about diversification, their go-to variable is correlation. Finding an asset with low correlation with equities and bonds is a key consideration of every asset allocator and chief investment officer (CIO) of an institution. But correlation is not everything.
What really matters for diversification is dispersion.A big concern of my friends who advise US clients these days is that their clients are losing faith in international diversification. After more than a decade of outperformance by US stocks, US investors are wondering why they should even bother with European or emerging market equities. European investors, on the other hand, are tempted to shift more and more of their equity allocation toward the United States. After all, the US market seems to be the only one doing well.
So when advisers or consultants show up and tell investors that international diversification is beneficial in the long run, they either quote John Maynard Keynes or suggest that the correlation between US stocks and those of other developed markets is so high that there is little benefit to diversifying.
As an example, over the last 100 years, the correlation between US and UK stocks was a whopping 0.7 — not perfectly aligned but close enough to warrant an arbitrage position from an arb hedge fund. Not much diversification benefit to harvest from UK stocks if you are a US investor, is there?
The chart below shows the difference in rolling 10-year total returns for US and UK stocks since 1920. Whenever the line is above zero, US stocks outperformed their UK counterparts over the past 10 years. When the line is below the zero, the opposite occurred.
US vs. UK Stocks: Annual 10-Year Total Return Differentials
Source: Fidante Capital
While the average performance difference between the two markets over the last 100 years is zero, the 10-year return differentials can be extremely large...MORE
