Location: Georgia Southern University, Georgia, United States

Wednesday, September 07, 2005

Even Homer Nods - critique of 8/23/05 WSJ column

The Wall Street Journal is our favorite newspaper. Being such big fans of the WSJ it pains us to see the paper commit a non sequitur. The August 23, 2005 Smartmoney Fund Screen article on Global Funds begins by asserting "It used to be a tenet of portfolio allocation that a well-diversified investor should maintain a careful balance between foreign and domestic funds, in order to avoid overexposure to slumps at home or abroad."

The column continues, "'s becoming less clear that mixing and matching funds by broad geographical categorization provides any protection at all." One assumes that since the topic is diversification, the idea of "protection" means from widely fluctuating returns. But what is the evidence cited to support the conclusion that geographical diversification is passe? - that the difference in returns over five years from different funds " little more than rounding error."

Well, concluding that diversification doesn't work anymore because the returns are similar is a non sequitur - it simply doesn't follow. Diversification is about reducing the volatility of portfolio returns, those ups and downs that cause investors to lose sleep at night. To say that investments that produce the same return over some period of time are equivalent is to ignore the risk of the investments entirely. The benefits of diversification are in risk reduction, not returns per se. To show that diversifying internationally isn't what it's cracked up to be requires showing that by some measure of volatility - variance or standard deviation of returns during the five-year horizon - there was no difference between the investments.

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