Risk can be divided roughly into two kinds: risk specific to a single asset or a single market, and systematic risk acting on all assets. The mechanism of diversification is to hold multiple imperfectly correlated holdings so that individual, uncorrelated risks offset one another, reducing the overall volatility of a portfolio. This mechanism works on the first kind of risk and not on the second. What global diversification mainly reduces is single-country specific risk. A country's policy changes, recession, currency crisis, or industrial structure problems are concentrated in that country, and holding assets across multiple countries lets such risks offset one another.
This is the core value of global diversification relative to holding a single country, and it has firm support in long-run data. What it cannot reduce is global systematic risk. A shock sometimes acts on all markets at once, whether a global financial crisis, a systematic liquidity squeeze or a common macroeconomic factor. Correlations across markets rise and the protection from diversification weakens. The rise in correlation during crises discussed earlier is exactly the expression of this limit. Global diversification cannot eliminate global risk. This distinction clarifies a common misunderstanding. Global diversification is not a universal tool that reduces risk in all situations.
It is a tool aimed at a specific category of risk. It reduces the volatility of a portfolio most of the time, and in a genuine systematic event the protection it can provide is limited. Expecting it to protect in a systematic crisis is a misunderstanding of its mechanism. Another point frequently confused is the difference between diversification and hedging. Diversification reduces volatility by holding multiple imperfectly correlated assets. Hedging offsets risk by holding an asset negatively correlated with an existing position.
What genuinely provides protection in a systematic crisis is the latter, an asset class negatively or lowly correlated with equities, rather than diversification among the equities of different countries. Global diversification also reduces a risk less often stated explicitly: the risk from home concentration compounding with human capital. As discussed earlier, most people's income, property and retirement arrangements are concentrated at home, and global diversification of financial assets can partly offset that existing concentration. The value of this layer is frequently overlooked in a portfolio measured in domestic assets. For investors, understanding precisely what diversification reduces avoids two opposite errors.
One is underestimating diversification, doubting its value because its effect weakens during crises, which ignores its role in reducing single-country risk most of the time. The other is overestimating it, treating it as protection against all risk and being unprepared in a systematic shock. Diversification is a tool with a defined range of effect, and understanding that range is the precondition for using it correctly. One practical inference follows. Where the main purpose of diversification is to withstand systematic risk, diversifying among the equities of different countries alone is insufficient. Asset classes with lower correlation to equities need to be included. This point matters more in the overall design of an allocation than the choice of which countries to hold, and it is the consideration most often left out.