New paper by Asness et al. International Diversification Works (in the Long Run)
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Conclusion
Over the short-term, global diversification can disappoint. Markets tend to crash at the same time and as a result, globally diversified portfolios are more negatively skewed. Critics argue that international diversification offers little protection vs. purely domestic portfolios and can in fact be more dangerous if investors rely upon their long-term reduced volatility.
We argue that this critique misses the point. While short-term common crashes can be painful, long-term returns are far more important to wealth creation and destruction. We show that over the long-term, markets do not have the same tendency to crash at the same time. This is not surprising as even though market panics can be important drivers of short-term returns, over the long-term, country specific economic performance dominates. Diversification protects investors against the adverse effects of holding concentrated positions in countries with poor long-term economic performance. Let us not diminish the benefits of this protection.
In a nutshell, international diversification works on a portfolio. Ignoring it is quite simply imprudent.
The paper has some useful illustrative tables and charts.Let’s use the Japan example again (while reminding readers that our results are not beholden to Japan). Japan’s disastrous 1990s did not happen because of a panic or globally coordinated rise in risk aversion, it happened because of a decade long idiosyncratic economic disaster. Our results say that while this event may be extreme, it’s directionally quite normal, and precisely what international diversification protects you against. Essentially, it’s quite arrogant for any investor to think their country can’t be the next decade’s 1990s Japan, and thus behooves any investor to diversify this possibility away. They just shouldn’t expect it to protect them from short-term crashes!
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