One of the popular ways to diversify that I see advised online is to allocate stock assets between US Total Stock Market (e.g., VTSAX) and International Total Stock Market (e.g., VTIAX). In fact, the stocks in a Target Retirement Fund like VTIVX are allocated between VTSAX and VTIAX.
Yet, when I chart the 10-year data of VTSAX vs. VTIAX by going here:
https://investor.vanguard.com/mutual-fu ... nd-returns
I see strong a correlation between between them. They're up and down basically in synchrony.
Does allocating stock investments between domestic and international stocks still reduce volatility? How?
Thanks.
VTSAX + VTIAX diversification
Re: VTSAX + VTIAX diversification
Diversification does not require zero correlation (which would result from independent assets). When there is a correlation, there is less diversification benefit, but still nonzero.
Suppose that Fund A and Fund B each are equally likely to outperform or underperform benchmark X by 5%, and those deviations are independent. A 50/50 portfolio of the two has a 25% probability of underperforming X by 5%, a 25% probability of outperforming X by 5%, and a 50% probability of matching X. Thus it has less risk than either individual fund, and because of the way compounding works, it will have a slightly higher compound growth rate. (To see the benefit of risk reduction on compounding, note that two years of 10% gains compound to 21%, while 0% and 20% over two years give 20%.)
While the numbers may not match, this is the same logic as combining US and foreign stocks. If US and foreign stocks have the same expected return, then a portfolio combining the two will have that expected one-year return with less risk, and slightly higher compounded return.
Suppose that Fund A and Fund B each are equally likely to outperform or underperform benchmark X by 5%, and those deviations are independent. A 50/50 portfolio of the two has a 25% probability of underperforming X by 5%, a 25% probability of outperforming X by 5%, and a 50% probability of matching X. Thus it has less risk than either individual fund, and because of the way compounding works, it will have a slightly higher compound growth rate. (To see the benefit of risk reduction on compounding, note that two years of 10% gains compound to 21%, while 0% and 20% over two years give 20%.)
While the numbers may not match, this is the same logic as combining US and foreign stocks. If US and foreign stocks have the same expected return, then a portfolio combining the two will have that expected one-year return with less risk, and slightly higher compounded return.