I am a CFA charterholder (chartered financial analyst), and have been one since 1997. Part of what we study involves the structure of portfolios and, more specifically, the methods that can be used to combine assets so as to minimize the risk in the portfolio, given the type of investments that are appropriate for the investor.

One of the key tenets of building efficient portfolios — those with the lowest risk given a specified level of return — is diversification. Diversification is simply putting various investments together that don’t act the same way, at the same time; in other words, if one goes down, another might go up, or at least is expected not to go down as much. The old saying “don’t put all your eggs in one basket” (because you might drop it), underscores the idea of diversification well.

One important aspect of diversification that many investment managers believe in, and sell to the investing public, is international diversification. Their belief is that, by investing in assets outside the United States, the risk in the portfolio will be reduced as compared with the same portfolio invested entirely in U.S. assets. This belief is based on many statistical studies that show, over long periods of time, assets outside the United States are not highly correlated — don’t move in the same direction at the same time — with U.S. assets. There is a lot of math that goes into calculating these correlations, but in general, we take the returns of all of the various assets in the United States and in other countries over a long period of time, and then compare those returns to see how they relate to one another.

For example, we could compare quarterly returns for large companies in the United States with large companies in Europe, over the past five, 10, 15 years, etc. We could use some intensive math to compare these returns over these various time periods to see how closely they follow one another. The more closely they track each other, the more highly correlated they are. The less they follow each other, the less correlated. If, on average when large U.S. companies performed well over a five-year period, which represents 20 quarters, and large European companies also performed well, on average, over the same 20 quarters, we would conclude that the two are highly correlated. If the opposite was true, we would conclude they are not highly correlated.

The point of all this is to find those assets that are not highly correlated and combine them into a portfolio so that when one market is performing poorly, the other is performing well, or at least not as poorly as the first. If large U.S. companies and large European companies are not highly correlated, and U.S. companies are doing poorly, (like they did in this most recent quarter), European companies should perform better. The combination of large U.S. and European companies in the same portfolio in this case should result in better overall performance than U.S. companies alone.

Modern portfolio management techniques are based on these long-term correlation calculations, which do show that U.S. assets in general are not highly correlated with assets in other countries. As a result, investors have been sold on the idea of including these foreign investments in their portfolios as a diversification tool. Anyone with investments today will know exactly what I am talking about.

The problem is, and this is the point of this article, this is wrong! One need only look at the most recent quarter, when U.S. stocks lost 12 percent, while European stocks lost 17 percent. In other words, to keep things simple, if a portfolio was 100 percent in U.S. stocks, it would have lost 12 percent for the quarter (assuming it was representative of the overall U.S. stock market), and if the portfolio was 50 percent U.S. and 50 percent European, the portfolio would have lost 14.5 percent — 2.5 percent more that the U.S.-only portfolio.

That’s right, diversification actually caused a larger loss! In fact, if the portfolio included any weighting in European stocks it would have performed worse than the U.S.-only portfolio.

Diversification is supposed to protect investors whenever the U.S. market gets hit by having money outside the United States, and again, with the assumption that these foreign investments are going to perform better than U.S. investments. We have seen time and time again in recent years that the exact opposite happens — when U.S. investments get hit, foreign investments actually get hit even harder.

Those who believe in international diversification will throw all kinds of arguments at me on this. They will claim there are not enough observations — the number of quarters in which diversifying internationally hasn’t worked — to “prove” my statement that international diversification is wrong. They might point to some obscure market that performed better than the U.S. market over this past quarter. They might point to those same statistical tests I mentioned above to say that over the long term, they will be proved correct and I will be proved wrong.

In my opinion, the global economy has changed. The integration of financial markets, government policies, the banking system, the Internet, access to information and a host of other factors have fundamentally and permanently changed the way investments work. As a result, there must be a complete sea change in the way investment portfolios are constructed and managed. International investments should only be included if they are expected to generate outsized risk-adjusted returns, and not because they supposedly diversify away risk (because they simply don’t).

So, the next time your financial adviser tells you that you need to buy foreign investments to diversify, at a minimum, question his basis for making this recommendation. After all, it’s your money at risk!

— Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at craig@craigdallen.com or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.