Whither Diversification?

Asset diversification has long been fundamental to investment risk mitigation. We compute new long-term country-specific indices of diversification potential for equity, sovereign debt, and real estate. Findings for the 1986-2021 study period indicate markedly declining or persistently dampened diversification potential for all asset classes. Declines in diversification potential for equities are especially pronounced among developed nations and coincide with higher levels of investment risk. Country-level panel analysis indicates that declines in diversification potential are associated with increases in the TED spread, country economic development, internet diffusion, political risk, and institutional ownership. Diversification potential increases with the Fed Funds Rate. Diversification potential waned temporarily among all asset classes during the 1992 ERM crisis and at the onset of the COVID-19 pandemic. Results are robust to measures of economic and financial market risk and to market liquidity. Findings offer a cautionary note regarding diversification of investment risk among asset classes and geographies in an increasingly connected and interdependent world.