Investors who are shunning the international equity markets because of the high correlation between U.S. and international stocks are losing out on significant diversification benefits, said Meir Statman, a professor of finance at Santa Clara University in Santa Clara, Calif.
The correlation coefficient — a measurement, expressed as a number between -1.0 and 1.0, that determines the degree to which two variables are associated — between U.S. stocks and the MSCI EAFE index was 0.86 for the five years ended Dec. 31, suggesting the returns of U.S. and international stocks move in the same direction at the same.
Mr. Statman, in a research paper he wrote with Jonathan Sheid, director of marketing and research at Assante Asset Management in Toronto, argued that investors must examine the dispersion of U.S. and international stock returns. He defines dispersion as the deviation between the returns and the combined mean return of both asset classes.
"Basically, it's tracking error," Mr. Statman explained. "If the dispersion of U.S. and international stocks is 3%, and if as an investor you chose to invest only in U.S. stocks because of the high correlation, the likelihood is that you will lag or lead by 3% someone who invests in a global diversified portfolio."
The research paper found the derived dispersion of a global equity portfolio invested equally between U.S. and international stocks was 4.55% between 1999 and 2003, and 5.02% between 1998 and 2002, despite correlations of 0.86 and 0.85, respectively. Mr. Statman explained: "My sense is that people are stuck on correlation for historical reasons. When people talk about the benefits of diversification, why not use a measure that is simpler and speaks more directly to the point?"