Practical Applications of Financial Globalization and Its Implications for Diversification and Portfolio Risk

Abstract

In Financial Globalization and Its Implications for Diversification and Portfolio Risk, from the October 2021 issue of The Journal of Investing, authors Ramu Thiagarajan, Jiho Han, Aaron Hurd, Hanbin Im, and Gaurav Mallik (all of State Street Global Advisors) explore why global stock investing has become less effective as a diversification strategy. From the 1980s until 2008, international markets became steadily more interconnected through trade and financial exchange. But starting in 2008, the global financial crisis, trade wars, and the COVID pandemic have caused a slowdown in international trade that some call “deglobalization.” However, financial globalization has continued to increase, due to increased worldwide use of the US dollar in transactions.

The authors focus on how increasing financial globalization impacts foreign stock markets and find that US monetary policy shocks (such as unexpected US interest rate hikes by the Federal Reserve) that cause US stocks to drop also cause foreign stocks to drop. They assert that financial globalization causes greater interconnectedness among financial markets in different countries, resulting in higher correlation of stock price movements across national boundaries. The upshot is that portfolios containing a mix of US and foreign stocks are becoming less diversified. The authors therefore suggest that investors explore diversification through alternative investments like commodities and currencies.