Geographical diversification: Risk reduction or Seeking Alpha ?

We are often told that diversification is highly beneficial for portfolio performance.

... which is only partly true, as markets are rather highly correlated. Correlation within economic sectors of enterprise stock prices across continents is even higher than the correlation between  different sectors of the economy on one single stock market. Correlation between asset classes has proved detrimental during the October 2008 market implosion.

If we are not successful in diversifying away risk, do we at least obtain any excess return?

In the Credit Suisse Global Investment Returns Yearbook 2011 (CS-GIRY - no longer available on the CS websute), national stock markets are compared and it is obvious that quite important disparities exist and persist. For all developed markets studied, three asset classes are considered. Over the last decade equity performs better than bonds in only four markets (South Africa, Norway, Australia and Denmark). Real returns (compensated for the CPI in the respective countries) are considered. This should enable a fair evaluation, provided that CPI reflects the true cost of living (?)

Nevertheless for international investments, the comparison is flawed. A long term change in a national index ought to be corrected for the variation of the currency exchange rate in the first place. Secondly the correction for the CPI on the domestic market equally affects all returns observed.

The graph below shows a twelve year overview of three market indices: for the US the Dow Jones Industrial (DJIA) on the left axis and the S&P500 on the right axis. Both axis are logarithmic. What was obvious in the CS-GIRY, namely that US stock markets are down over the first decade of the century in real terms, is confirmed here (as the S&P500 doesn’t even uphold in nominal terms). Real returns include dividends reinvested but are compensated for inflation. As the dividend yield has been low throughout the decade, dividends have not compensated for inflation.

Dow Jones, S&P500 and the German DAX index, compensated for the USD/EUR exchange rate

The third index included is the German DAX index (on the left scale), recalculated to compensate for the EUR/USD exchange rate fluctuation. The DAX starts off poorly in 1999 as the common currency starts its life with an initial decline to the USD. The new millenium is a boost for the DAX and it gradually recovers some loss incurred because of euro weakness. The dotcom bust affects the german market DAX more than it does the S&P or the Dow (since the tech sector is more concentrated on the Nasdaq).

The March 2003 bottom is a turning point and the recovery of the DAX is boosted by a simultaneously rising Euro. By the beginning of 2008, the DAX has almost bridged the gap with the Dow. The October 2008 market implosion creates a scramble for dollars and the decline of the DAX is once more aggravated by a plunge of he euro. On balance, the DAX recovery ever since has been getting a helping hand from dollar weakness. For US investors, the forex variance adds up to the DAX variance in euro, which cranks up the volatility of the DAX converted to USD.

Conclusion
 Over twelve years, the stock markets cycles of the leading economies at either side of the Atlantic have been highly correlated. Both the dotcom bust as implosion of the financial sector affected both, with the German market more affected because of dollar strength during financial hardship. Over the long run, investing in the German stock market did provide an edge, some of which is due to the Euro strenghtening over the long haul. Advantage comes at a price: for US investors the volatility of the german DAX index is higher.

What about a 'Eurocentric' perspective ? A posting (in Dutch) includes a similar graph, with the DAX as observed, but the Dow and S&P500 converted to Euro. (Posted on May 17).