Portfolio Design: A Modern Approach to Asset Allocation

DIVERSIFICATION BENEFITS OF FOREIGN STOCK INVESTING

A traditional argument in favor of diversification into foreign stocks was the relatively low correlation between foreign and domestic stocks. This low correlation meant that the risk of an internationally diversified portfolio could be lower than that of an all-U.S. portfolio. Over the period from 1970 (when the EAFE index begins) and 2009, for example, the correlation between EAFE and the S&P 500 index is only 0.60. The effects of this low correlation have often been illustrated using a horseshoe diagram like that found in Figure 5.8. The horseshoe shows various portfolios of U.S. and foreign stocks ranging from an all-S&P 500 portfolio (at the lower right end) to an all EAFE portfolio (at the higher right end). The powerful message of this chart is that diversified portfolios of foreign and domestic stocks have the dual benefit of lower risk and higher return. The horseshoe diagram was often used in the marketing materials of foreign stock mutual fund managers during the mid-1990s. Then for about 10 years, the horseshoe disappeared as a marketing device because EAFE was being outperformed so badly by the S&P that the horseshoe inverted. Diversified portfolios still lowered risk, but portfolios with high proportions of foreign stocks had lower returns than U.S.-only portfolios. With the surge in foreign stock returns since 2002, the horseshoe has become viable again. But notice that in Figure 5.8, the gap in returns between ...