One is that it is in the interest of emerging market countries

One is that it is in the interest of emerging market countries,
like China, to continue to provide the financing needed to bridge
the deficit gap. This is because much of the American spending
that creates the deficit is on products from emerging market
countries. And that buying is fueling these countries’ economic
growth and creating millions of new jobs.

The current account deficit

Of deficits, there are two, the current account deficit and the
federal budget deficit. We think the current account deficit, which
is the gap in the trade of goods and services that the United States
has with the rest of the world, is not a big threat.

Another argument for sector investing

Another argument for sector investing is that if you just diversify
by country using main market indexes, you can get big distortions
in your portfolio.

If you love stocks

Some longtime investors who think a lot about risk, like Peter
Bernstein, the author of Against the Gods: The Remarkable
Story of Risk (John Wiley & Sons, 1996), want to have an
added hedge in their portfolio just in case the worst happens. A
hedge is a bet against your main strategy—which is why you
pray you are wrong to make this bet. You should hedge
against a low-probability occurrence that could have very big
consequences.
Here is an example: If you love stocks, load up, but put a
small portion of your portfolio into long-dated zero coupon
bonds—5 percent to 10 percent, say, depending on the seriousness
of the consequences if the worst happens. You pay well
under the face value for these bonds because there are no cash
interest payments to you. You get the implied interest payments
back when the bond matures and you are paid its face value. If
something bad happens that drives interest rates and stocks
sharply lower, like a recession, 30-year zero coupon bonds do
very well. If interest rates fall by two full percentage points, the
value of the zero coupon bonds would go up 60 percent.

DIVERSIFYING BY ASSET CLASS

While diversification abroad, as a way to reduce risk in a stock
portfolio, has become less rewarding because of rising correlations,
diversification by asset class is still holding its own. Correlations
between stocks and commodities and stocks and bonds
are still very low, although there will always be periods when they
all follow each other.
This is not only a good idea because of the theory of diversification;
it is also a good idea in a world where financial advice—
including this book—is ever more available to the everyday
investor. There are many more voices out there advising investors
to do this or that. A lot of this advice is to jump onto this bandwagon
or to jump off of that bandwagon. And because it is so
much easier for retail investors to put this advice into action, diversification
is a good hedge against the problem with following a
lot of different financial advice: Some of it is wrong.

MSCI to the U.S. market

Take South Korea, for example, whose stock market capitalization
accounted for 15.5 percent of the MSCI emerging market
index. South Korea’s correlation with the American market has
surged, doubling in the three years from April of 2000 to April of
2003 to 0.607. By December of 2006, the correlation level was
up to 0.649.
At the same time, the correlation level was also rising sharply
in the fifth largest emerging stock market, Brazil, which was 10.5
percent of the emerging market index at the end of 2006. Its correlation
had jumped to 0.705 by May of 2005, more than doubling
from the level in July

Correlation of emerging markets

As in developed markets, the correlation of emerging markets
to the United States went over 0.6 in August 1998 and has stayed
above 0.6 since. Before then, the closest a correlation had gotten
to 0.6 was 0.548 in July 1995, according to the analysis of stock
market return data from MSCI that begins its monthly readings
of five-year rolling correlations in December 1992.