In a well-diversified portfolio as one asset class declines another should rise mitigating risk and minimizing losses the graph illustrates the return versus the risk for two asset portfolio. The line is an efficient Frontier representing every possible combination of assets that maximizes return at each level of portfolio risk and minimizes risk at each level of portfolio return inefficient Frontier is the line that connects all optimal portfolios across all levels of risk and optimal portfolio is simply the mix of assets that maximizes portfolio return at a given risk level this image illustrates an efficient Frontier for all combinations of two asset classes stocks and bonds. Although the bonds are considered less risky than stocks the minimum risk portfolio does not consist.
Hourly of bonds. The reason is that stocks and bonds have seen low and in some cases negative long-term correlations, for example, the correlation between Global stocks and Global bonds over the last 30 years is about 0.29. That is they tend to move independently of each other sometimes stock returns may be up while Bond returns are down and vice versa these offsetting movements help to reduce overall portfolio of volatility as a result adding just the small amount of stocks to an all-bond portfolio actually reduced the overall risk of the portfolio.
However, including more stocks Beyond this minimum Point caused both the risk and the return of the portfolio to increase.
In this table, the highest correlation is between us small company stocks and US mid-cap Stocks, whereas the correlation between us company stocks and international stocks is a little lower. Although these are the highest correlations. They still provide diversification benefits because the correlations are less than one some of the lowest correlations are between stocks and bonds with some being negative. The low correlations between stocks and bonds are attractive for portfolio diversification similarly, including International Securities in a portfolio can also control portfolio risk. It is not surprising that most Diversified portfolios of investors contain domestic stocks domestic bonds foreign stocks foreign bonds real estate cash and other asset classes here. We see International stocks have provided better diversification versus US equity subclasses.
In addition to the major asset classes seen here Industries and sectors are used to diversify portfolios. For example Energy stocks may not be well correlated with Healthcare stocks the exact proportions in which these assets should be included in a portfolio depend on the risk return and correlation characteristics of each and the home country of the investor. It is also important to note that correlations are not constant over time during a long historical period the correlations of returns between two asset classes may be low, but in any given period the correlation can differ from the long term correlation estimates can vary based on the capital market dynamics During the period when the correlations are measured During periods of Market crisis correlations across asset classes and among equities themselves often increase and reduce the benefit of diversification.
By ignoring investment opportunities outside of the Home Country investors are missing out on a large portion of the investable opportunities in the world this image illustrates, the relative size of international and domestic markets at year-end 2018. The international markets represented in the image constitute those countries having developed economies some of which had established markets before the United States in 2018.
The developed World stock market capitalization was 40.6 trillion with 18.5 trillion representing International that is outside of the US total stock market capitalization if the US Stock Market represent the only Securities in your portfolio, you are ignoring just under half of the world's investable assets.
The rationale for diversification outside a local market is clear domestic equities tend to be more exposed to the narrower economic and market forces of their home Market while stocks outside an Investor's Home Market tend to offer exposure to a wider array of economic and market forces these differing economies and markets produce returns that can vary from those of an Investor's Home Market.
Regardless of where they live investors have a significant opportunity to diversify and reduce the risk of their portfolios by investing outside their home Market despite this opportunity investors on average have maintained allocations to their home country that have been significantly larger than the country's market capitalization weight in a globally Diversified Equity index in particular. The Chinese market has historically seen a low correlation with the global Equity markets one important reason is that the market has long been closed to foreign investors and therefore has not moved in step with global sentiment. And while the ongoing opening up to foreign investors will eventually increase the markets correlation with other Equity markets. This will likely take some time.
The investment region or asset class that outperforms one year might underperform the next and the asset class that outperforms over a 10-year period might disappoint over the next decade history has demonstrated that it is very difficult to predict which regions are going to lead in which ones are going to Trail in any given year.
US Stocks have outperformed non-us stocks in recent years some investors have again turn their attention towards the role that Global diversification plays in their portfolios.
The last decade is often used to describe longer periods of poor performance. This applied to Japan throughout the 1990s and the US for the prior 10 years to the data shown.
During that time the S&P 500 Index recorded its worst ever 10 year performance with a total cumulative return of negative 9.1 percent. However, looking Beyond us large cap equities conditions were more favorable for Global Equity investors as most Equity classes outside the US generated positive returns over the course of the decade while the performance of different countries and asset classes will vary over time. There is no reliable evidence that this performance can be predicted in advance and approach to investing that uses the global opportunity set available to investors can provide diversification benefits as well as potentially higher expected returns.
