Blog #31 Dance of the Stock Markets

Is the world getting closer? Are stock markets more correlated than ever before, thereby negating the benefits of global diversification?  If the answer to both of these questions is yes, then you won’t have to worry about which stock market in invest – just buy the STI ETF if you are based in Singapore.  But if markets are not getting closer, then owning just Singapore stocks is not going to be a smart way to grow your wealth or manage your portfolio risk.

How to find out? I’ve trawled the data of 17 stock markets other than Singapore from various databases to give you the straight answer from the perspective of a Singapore-based investor.  The 17 markets are: Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Italy, Japan, Netherlands, Norway, Spain, Sweden, Switzerland, the UK, and the US. In terms of market capitalization, they are virtually the whole world.  My sample period is from Jan 1970 to Jun 2017 (roughly 18 years) and my data consists of monthly inflation-adjusted returns in Singapore dollars (i.e., the returns of each of the 17 markets are converted back into Singapore dollars to simulate foreign currency exposures).

First, some basic facts about what this data tells us about global equity risk and returns. Over this period, the average return and risk of the Singapore stock market was 9.2% and 26.1% respectively. If you divide the mean by the volatility, you get a reward-to-risk ratio of 0.35. The higher this ratio is, the better.  A ratio of this magnitude (0.35) is typical of developed country stock markets over the long run.

How about the world portfolio?  I construct this portfolio by assuming every dollar is split equally across the 17 markets. The average return and risk for this highly diversified portfolio is 6.8% and 13.3% respectively.  Hence, the world portfolio wasn’t as good as Singapore in terms of average return. But prudent investors care not just about average returns but also about risk.  The reward-to-risk ratio takes care of that.  This ratio (6.8% divided by 13.3%) is 0.51, which is well above that of Singapore.  I declare the world portfolio the overall WINNER.

The world portfolio has lower risk because it has “eggs in different baskets” so to speak. As a result, no single market calls the shots but all markets contribute their fair share to overall volatility. To use the jargon of finance, returns across markets are not perfectly correlated (if they were, the correlation index would be a 1).

The average correlation between Singapore and the world portfolio is about 0.57 based on monthly returns over 5-year rolling periods. Importantly, this correlation is far from perfect.  A plot of the rolling 5-year correlations is shown below.

Correlations.jpg

You can see that there are a 3 periods when the correlation is above 0.7. These periods and their correlations are:

1975-79 (0.76) 
1990-94 (0.75)
2005-09 (0.88) 

These high-correlation periods coincided with negative world events like oil shocks and recessions (the first period), wars (the second period) and banking crises (the third period). Due to their global nature, Singapore’s stock market performed relatively better than the world portfolio. Other than these correlation spikes, the correlation index between Singapore and the world portfolio is typically in the 0.4 to 0.6 range, which isn’t too high, which is good for diversification.

For another piece of evidence that global diversification pays, we can look at the reward-to-risk ratio for Singapore and the world portfolio across different periods. This is shown in the next chart which shows the reward-to-risk ratio for separate 5-year periods from 1970 to 2017. The world portfolio has a higher reward-to-risk ratio in 6 out 10 5-year periods, and almost the same ratio in one other period.  I declare the world portfolio as the WINNER for a second time.

Reward to Risk.jpg

Conclusion: International trade and communications may be bringing countries closer together, but individual stock markets still dance to their own home tunes. This is most likely due to the “home bias” e.g., the tendency for Singapore-based investors to invest mainly in Singapore rather than global stocks.  My data shows that staying at home isn’t a good a strategy as many investors think it is.  It’s time to change mindsets.

 

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