In normal times, the equity markets of different countries are driven by their own economic cycles, industrial structures and local factors, so correlations are incomplete. That incompleteness is the basis of diversification. When one market falls, another does not necessarily follow, so the overall volatility of a portfolio falls below that of the individual markets. Long-run data supports the existence of this effect. The pattern during crises is different. When a global shock arrives, whether a financial crisis, a liquidity squeeze or a systematic repricing of risk, correlations across markets rise substantially and often approach synchronised decline.
This phenomenon recurs across multiple crises, and its meaning is that diversification provides the least protection precisely when it is most needed. One mechanism behind rising correlation is a common source of capital. When global institutional investors face redemptions or pressure to deleverage, they sell assets across multiple markets at once. That selling has nothing to do with the fundamentals of any market. The common source of capital means markets ordinarily driven by different factors become dominated by a single flow during stress. A second mechanism is the synchronisation of risk sentiment. In normal times, investors distinguish the individual conditions of different markets.
Under stress, that distinction yields to a binary judgement between seeking safety and accepting risk. When all risk assets are grouped into one category and sold together, the correlation among them naturally rises, and individual differences in fundamentals lose their force temporarily. It is worth noting that this rise in correlation is usually temporary. After a crisis, markets gradually return to being driven by their own factors, correlations fall, and the benefit of diversification recovers. This means the high correlation observed during a crisis should not be extrapolated as a long-run norm, however strong it feels at the time.
The implication for diversification needs to be understood precisely. It does not mean diversification is useless, since across most of the time it does reduce volatility. It means the protection weakens during extreme systematic events. What genuinely provides protection in a systematic crisis is an asset class with a stable negative or low correlation to equities, not diversification among the equities of different countries. For investors, this understanding avoids two errors. One is rejecting the value of diversification because correlation rises during crises, which ignores its role most of the time.
The other is overestimating the protection cross-country equity diversification provides in extreme events and being caught unprepared when a genuine systematic shock arrives. The correct understanding sits between the two. A practical corollary follows. Where the main purpose of diversification is to withstand systematic risk, diversifying among the equities of different countries is not sufficient on its own. Asset classes with lower correlation to equities have to be included as well. This consideration matters more in the overall design of an allocation than the choice of which countries to hold. The instinct to add another country during a decline addresses the wrong layer of risk, since in the moment that prompts the instinct the countries are moving together anyway.