It has been shown that portfolio risk is reduced by introducing shares from emerging countries, whose volatility is nonetheless much greater than that of industrialized countries. The key to the mystery is that the shares of the former are only weakly correlated to those of the latter. Portfolio performance is enhanced once shares of emerging countries are brought into the mix. At least that is the case in normal times. Financial crises occasionally breed correlations that foil the best-laid mathematical schemes.
During a stock market crash in a given country, it often happens that the local currency also bites the dust. Losses for a foreign investor are even more agonizing than those suffered by a domestic investor; this is due to the correlation that appears in times of financial crisis between exchange rate risk and overall market risk. In the Mexican crisis from December 1994 to March 1995, shares dropped by about 30 percent. That said, over the same period an investor who had acquired Mexican stocks with dollars would have endured a loss of 65 percent – 35 percent more – on account of the devaluation of the Mexican peso in relation to the American dollar.
A financial crisis makes correlations appear in places where they were not expected. The ‘‘tequila’’ effect of the Mexican crisis made investors massively sell off their shares in emerging countries. So it was that the crash spread to numerous Latin American countries and also had a ripple effect across the Pacific, in Indonesia, Thailand and the Philippines.
In fact the risk of a security is composed of two distinguishable sets of risks. Systematic risk is that which cannot be eliminated through diversification strategies. It is the risk inherent to the system, the market risk. Specific risk is proper to the financial asset under consideration. It is a reflection of the risk that something happens and affects the asset (and the asset alone). This risk disappears by dint of diversification.
These two risks are independent; their correlation coefficient is 0. Total risk is the sum of the two. Three experts – William Sharpe, John Lintner and Fisher Black – have put this observation to work by building the Capital Asset Pricing Model (CAPM). The CAPM indicates the price of risk. You may recall that Louis Bachelier established that: ‘‘The mathematical expectancy of the speculator is zero.’’ As for the CAPM, it establishes a simple rule on the basis of two hypotheses: markets are in equilibrium; all investors believe in Markowitz’s theory and they choose their investment out of the same set of efficient portfolios. The rule postulates that the mathematical expectancy for an investment in a security or a portfolio must be proportional to the systematic risk. Since specific risk may be eliminated by diversification, it will not be remunerated by the market. On the other hand, the value of a portfolio has to include remuneration for the investor of an amount in proportion to the degree of systematic risk.
Market risk is attributable to the ongoing evolution of financial assets; it dictates the fluctuation of a given security. Some stocks react strongly to market movements; others do not. The degree of sensitivity to overall market fluctuation proper to a given security is known as the beta coefficient (the estimated coefficient of independent variables in a regression equation). It historically measures the systematic risk proper to a given security on the basis of comparison between the price fluctuations of the security and the fluctuations of the financial market taken as a whole. A security with a 1.0 beta presents the same risk as the market. With a beta lower than 1.0, its risk is also lower than that of the overall market; the security attenuates market fluctuations. With a beta higher than 1.0, the security tends to amplify market fluctuations. With a beta of 2.0, the instrument moves twice as much as the market. If the market rises by 10 percent, it goes up by 20 percent; when the market falls, it goes just as precipitately down. Yet for a given security, the beta does not necessarily hold steady. In other words, it takes on different values in accordance with the periods for which it is measured. On the other hand, the beta value of a market portfolio shows more stability over the course of time. It measures the responsiveness of this portfolio to market fluctuations; it quantifies its volatility.

It is often supposed that investors do not like risk; they are convinced that the good surprises fail to compensate for the bad ones. They would consequently prefer the same returns while incurring a lower degree of risk.
The more the correlation coefficient is negative, the more one endeavors to diminish average risk by applying negatively correlated instruments. If the investor is indeed ‘‘risk-averse’’, he will make sure that the latter are as negatively correlated as is feasible. Then again, the mere fact that the financial instruments are not strictly correlated enables diversification to play an appreciable role.
The correlation of two financial instruments takes on a value between – 1 and + 1. The lower the correlation between a financial asset and a portfolio, the more the volatility of the latter is diminished once the former is added to the portfolio. If one adds securities that are negatively correlated with the portfolio, then the volatility of the latter will be very much diminished. If the new financial assets have no correlation with the portfolio (its coefficient correlation is 0), adding such a security will nonetheless reduce the volatility of the portfolio. Even with a positive correlation coefficient, provided that it is less than 1, adding a supplementary asset diminishes the risks incurred by a portfolio. If we limit ourselves to stock portfolios, studies show that maximal risk diversification is attained with at least 20 shares of firms operating in heterogeneous industrial sectors. Needless to say, if you specialize in stocks for skis, ice skates, fur jackets and 17 shares in industries related to cold weather, your portfolio will be poorly diversified notwithstanding your 20 shares! In contrast, you must try to introduce shares that are not positively correlated. It is also necessary for the probability distributions and the degrees of correlation between them to remain stable for a sizable length of time. The more we study long periods of time, the less reliable are the available statistics. How long is long enough? During calm spells studies by institutional investors analyze and survey the degrees of correlation that may exist between the different categories of financial assets: the stocks of large-scale groups, medium-sized companies, government bonds, corporate bonds, junk bonds, real estate, hedge funds and so on. One must remember that securities that are riskier than a portfolio when taken individually may, in spite of everything and provided that they are not correlated with the portfolio, reduce the overall risks of the latter.
Such factors help to explain the interest in international diversification; it can be expected that economic crises will not take place simultaneously in every country. This approach is supported by the observation that in each country, stocks evolve as a function of the ups and downs of the local economy. Money flows likewise introduce negative correlations between stock market performances and exchange rates. Lowering risk through international diversification largely compensates for the risk linked to exchange rates. Yet with the ongoing internationalization of the activities of quoted companies, the impact of purely local or national factors tends to diminish. A French economist, Bruno Solnik, has shown that for an internationally diversified firm, asset returns are determined to a significant extent by non-domestic (rather than domestic) factors. Moreover, the sensitivity of individual company returns to non-domestic factors is integrally linked to the scope of their international activities, as represented by the relative importance of foreign sales in relation to total sales.