Where to hide in bad times: Or should one still diversify internationally?

It is well documented that correlation between international equity indices
has trended upward for many years. This trend has called the concept of
diversification into question. In this paper we argue that this argument is
informed mainly by restrictions in modeling choices or portfolio solutions.
We examine the fundamental question of whether there is economically
significant gain of international exposures in the investment portfolio
after capturing stylized dynamics of the data for short- and long-term
return horizons and after accounting for intertemporal hedging. The answer
is yes and the gain is substantial over a long horizon and for a reasonable
range of international equity indices. First, a diversifying investor
benefits from periods of low correlations of higher moments and time
variations in return co-movement measures. Second, the cost of home bias
comes primarily from not hedging changes in correlation and tail risks
present in data, and cannot be solely explained by mean-variance
considerations.