The Global Investment Conundrum

Free trade and the liberalization of economic policy is inherently a good thing. The free flow of goods from one country to another typically generates wealth and investment opportunities for both the buyer and seller. On the contrary, there is always an element of risk associated with a percent gain or loss of return. The correlation coefficient multiples for each asset class takes into consideration the country that which a specific security originates, is an important determinant of risk for international portfolio diversification.

Dr. Cheol S. Eun (Ph.D., NYU, 1981) Professor of Finance at Georgia Institute of Technology, writes, “The magnitude of gains from international diversification in terms of risk reduction depends on the international correlation structure.”

Most of us are aware that there is an amplified stock market rally in the United States, ever since the U.S. election in early November 2016. This was an unexpected externality which resulted in gains for some and losses for other investors who own U.S. based equities.

This type of sudden volatility movement, associated with the large cap equity indexes (Dow Jones, for example), was not necessarily witnessed around the world with alternative international equity indexes.

Did the U.K. FTSE 100 also witness an upwards bull market trend (post-U.S. election) as with Hong Kong's Hang Seng index?

Both the U.S. and the U.K. apparently have many similarities in terms economic policy, trade, language, and values from a current macro-level political perspective.

The charts below will compare the U.S. Dow Jones, to the U.K. FTSE 100, and the Hong Kong Hang Seng index.

Chart 1 (Dow Jones):

(source: yahoo finance)

Dow Jones 01 NOV 2016 was less than 18250, and by the end of December 2016, the index was hovering just under 19800. Clearly an upward swing.

Chart 2 (FTSE 100):

(source: yahoo finance)

The FTSE 01 NOV 2016 was less than 6750, and by the end of December 2016, the index was hovering just under 7150. Similiar to the U.S. there has been a positive increase in value.

Chart 3 (Hang Seng Index):

(source: yahoo finance)

On the contrary, when we analyze the Hang Seng Index, in early November 20016 the HSI was approximately 2350, and the index started to decrease in value post-U.S. election. Note how by the end of the 2016 calendar year the index was valued at a lowered value of 2200.

From a risk-averse international diversification perspective, I would recommend an investor to purchase both U.S. and H.K. based equities. Furthermore, from a pension owner perspective, you don’t necessarily want to make more than a 3 – 4% gain on an annual basis. This type of high volatility and return can be considered a high risk for conservative long-term investors (fixed income).

Is this just a matter of coincidence? Not necessarily, Dr. Cheol S. Eun developed the chart below which reflects a lower correlation coefficient between a U.S. & HK portfolio of .48 and a U.S & U.K. correlation coefficient of .72.

(Chart date: 2015)

The higher the correlation coefficient among the two countries, the more interconnected they are with market swings. International diversification is a good thing when managed in a carefully calculated manner, taking into account risk and return.

It’s profound to think that the more global the world becomes in regards to economic liberalization, the higher the risk associated with a diversified portfolio, based upon an increase of correlation coefficients.

Source: Eun, Cheol S., Resnick, Bruce G. (2015) International Financial Management, seventh edition. McGraw-Hill Education.