Diversification is a big word in investment circles. The thinking is to diversify your investment holdings so that if a problem arises in one area, you still have another area that is not related to that area so your whole porfolio does not suffer. Don't put all your eggs in one basket they tell us. Invest not only domestically, but also invest in foreign investments. It used to be good advice. However, that advice is increasingly becoming bad.
However as the above chart shows, there is an increasingly greater correlation between global stock stock markets. In other words the USA DOW increasingly looks like the German stock market or the Hong Kong stock market.
Why is this happening. This article in the Economist points out three reasons:
1) Globalization- there are so many multi national companies. A firm based in Lima, Peru may show loss or gain depending on the economy in South Korea. If South Korea tumbles, Peru goes down with it.
2) Federal Reserve- The Fed is largely responsible for monetary policy in the United States. It has the power to raise or lower the dollar supply. Since the US dollar is the worlds largets reserve currency, the Fed and its policies on the dollar affects anyone that uses the dollar (which is most of the world).
3) Large fund management firms -
"Another crucial factor may be the existence of large fund-management firms, whose portfolios are diversified across the globe. A new academic paper* looks at how these funds may act to transmit shocks from one market to another.
Fund managers do not make their buy-and-sell decisions based on the economic fundamentals alone. They have to adjust their portfolios as clients send them more money or ask to redeem their holdings. If retail investors in Iowa want their money back, fund managers have to sell something and that may mean Brazilian or Chinese equities.
Those Iowans may well be reacting to domestic news, such as the debt-ceiling crisis in late July or Standard & Poor’s downgrade of America’s credit rating. But the result of their actions is that global markets fall in unison. The authors describe the process in this way: “Global funds substantially alter portfolio allocations in emerging markets in response to funding shocks from their investor base.” They found that those emerging markets that were most exposed to these global funds were both more correlated with one another, and more correlated with the developed markets in which the funds are domiciled.
There is an irony at work here. Global funds are invested in Brazil and China because investors want a diversified portfolio. But the very act of diversification means that these markets become more tied to the developed world and the rewards of diversification are accordingly reduced. It is not really diversification when everyone has the same idea."