The underlying reason for a diversified portfolio is that it is typically less risky than a concentrated portfolio. The old caution against "all one's eggs in one basket" applies. One problem that may arise in using this rationale is that sometimes investing in both A and B does not really reduce risk if A and B are themselves highly correlated. They are, then, too much like the same basket.
The case for a diversification of one's portfolio by nation arises from the low correlation of the markets of different nations. But some scholars, such as professor Burhan F. Yavas of the Graziadio School of Business at Pepperdine University, writing in 2007 in the Graziadio Business Report, contend that over time there is a "growing interdependence among the international markets," such that the "benefits of international portfolio diversification may be overstated."
Nonetheless, Yavas concluded that the benefits remain real. Specifically, an investor based in the United States will receive a small diversification benefit from owning assets in Germany, and a larger diversification benefit from owning assets in Japan.
The diversification benefits from Japan are greater for reasons of distance and the direction in which the planet turns. "The German market has a one-hour overlap with the U.S. stock market," Yavas wrote. This helps produce correlation. "However, the developments in Germany and in the U.S. are not reflected in Japan until the following day."
One intuitive point is that no nation contains a monopoly on good business opportunities, so a savvy investor will not limit her portfolio to her home nation. As the large brokerage firm Charles Schwab has said, "International investing is no longer the exotic, only-for-the-pros endeavor it used to be." In particular, some of the most promising pharmaceutical companies, banks and automakers are based outside of the U.S.
Diversification by nation protects against the risk that any one of the governments involved will undertake a ruinous policy. Ian Bremmer, the president of a political risk consultancy, writing in "Inc." in April 2007, noted that small companies may be better able to protect themselves against political risk in this way than their larger counterparts.
"Like speedboats maneuvering nimbly among aircraft carriers, small companies can respond more rapidly than large corporations to shifting political and economic conditions. With fewer fixed-asset investments, they can more easily pounce on new opportunities and exit when changing costs and benefits warrant," he wrote.
Good Times and Bad
It is important to note that diversification does more than cushion disasters. It makes the good years better ones. In 2006, every major index of U.S. stocks was up by double digits. Even in that environment, though, international stock funds gained more than domestic stock funds: international funds returned 25.5 percent vs. just 12.6 percent for U.S. stock funds.
Christopher Faille is a finance journalist who has been writing since 1986. He has written for HedgeWorld and The Federal Lawyer and is the author of books including "The Decline and Fall of the Supreme Court." Faille received his Juris Doctor from Western New England College.