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Investors in global equity markets have traditionally hedged their bets, casting their investments far and wide across the world. That way, if the market in one country or region stagnated (think Japan in the 1990s or Europe in the 2000s), they could make up the difference in other sectors that are booming.
However, as markets in different countries have increasingly moved in tandem or correlated, from 50 or 60 percent in the 1990s to more than 90 percent after the financial crisis of 2008, that strategy has seemed less and less worthwhile.
“The claim is that it makes less sense to be diversified than it used to in the past, since, at the end of the day, all markets are moving together,” says Luis Viceira, George E. Bates Professor and Senior Associate Dean for International Development at Harvard Business School.
All things being equal, that means instead of spreading the wealth around, investors should put their money in places that are familiar—usually their own country. “There is a very well-known phenomenon called home bias,” continues Viceira. “People think they know their own stock market and feel more comfortable investing in it, and they overestimate the risks of investing abroad.”
Home bias is short-sighted
In a recently released working paper, however, Viceira argues that such an investment strategy may be unwise for investors in the long run—not to mention damaging to the global economy overall. Written with HBS doctoral students Zixuan (Kevin) Wang and John Zhou, Global Portfolio Diversification for Long-Horizon Investors has become one of the top downloaded papers on the online Social Science Research Network, sparking intense interest in the value of diversification in global investing.
“People are intrigued by what this means about their own investment portfolios, and whether they should be investing more in the United States or globally,” Viceira says.
First things first. Why have markets become increasingly correlated? The paper proposes two possibilities. The first theory is that fundamentals in different countries have become more similar with time. So, while industries within a country might move separately, all that variability comes out in the wash when you average across a broad array of industries on a countrywide scale. “You don’t see the stock price of an energy company in Texas always moving in sync with the stock price of Facebook,” says Viceira, “but when you look at national markets of developed economies, they all have utilities, airlines, manufacturing companies, telecom companies, so you might expect them to move together more than any individual stock.”
Being globally diversified is basically making a bet that the global economy will be in a better position in 20 or 30 years than it is today
The other possibility for increased market correlation is not because national economies have become more intrinsically similar, but because investing has become more global overall, so large equity firms are moving their money together based on the same sentiments. “Today, we have truly global asset managers that make it easy and cheap for any investor to invest in every market. This facilitates the transmission of investor sentiment across markets,” says Viceira.
“If you have the same investors everywhere, they get scared at the same time and all pull out together,” says Viceira. The underlying value of the market, however, may not have changed, rather, investors are selling it at a discount. “For the same set of cash flows, they are willing to pay less. Of course, the reverse happens when they become bullish about stocks. These sentiment waves correct themselves, and fundamentals prevail in the long run.”
Viceira and his colleagues used a complex econometric model to determine which of these two possible explanations appears to be a better description of the evolution of global capital markess. Using stock market data for the largest seven developed countries between 1986 and 2013, they disentangled changes in the prices of securities versus their value.
“This is how you can piece out whether a positive return in the market was because something in the fundamentals changed or because of a change in investor sentiment,” he says.
They found overwhelmingly that it was investor sentiment that became more correlated, not the underlying fundamentals. Because those sentiments tend to be transitory in nature, however, long-term investors shouldn’t worry so much about moving their money when those shocks occur.
“They should be less concerned about that, because they can ride out those waves,” says Viceira. Thus, for investors looking beyond a 10- to 20-year time frame—including individuals saving for retirement, college endowments, foundations, pension funds, and sovereign wealth funds—global diversification still makes sense.
In fact, says Viceira, not diversifying can hurt those investors by causing them to miss the more dynamic parts of the economy if they get stuck in one country that is stagnating.
The advantage of diversification
On the other hand, for short-term investors, it’s a different story. Since they are more exposed to transitory changes in market value, they are less able to ride out those discount shocks caused by investor sentiment. “If you have to liquidate your holdings in the short term, then being diversified doesn’t help as much as it did 30 years ago,” says Viceira.
Even for those investors, however, there is still a reasonable advantage to diversification. And for the global equity market as a whole, Viceira says there are big benefits to having individual investors who are diversified across countries. “It immediately generates more capacity in global markets to provide capital in an economy, and that increases their ability to absorb risk.”
Thus, diversification becomes self-reinforcing, making global financial markets more stable, at the same time allowing investors to profit from increases in value wherever they occur. Even while diversification will inevitably lead to risk from investments in companies that aren’t doing so well, overall, it leads to greater risk-adjusted returns in the long term.
“Being globally diversified is basically making a bet that the global economy will be in a better position in 20 or 30 years than it is today,” says Viceira, “and I think that is safer than betting on any one specific economy.”
