Excellent article, Peter. It's very, very important to diversify using asset classes that provide not only low correlation with what's already in the portfolio but also high risk-adjusted returns on their own. Most people seem to get the first part of that (although not necessarily why), but often they forget to pay attention to the second part: after all, money stashed under the mattress has a correlation of zero with every other asset class, but it doesn't help your portfolio maintain good returns, even on a risk-adjusted basis.
The rule is this: if the Sharpe ratio of any new asset class is greater than the Sharpe ratio of the existing portfolio multiplied by the correlation between the existing portfolio and the new asset, then adding the new asset will improve the risk-adjusted returns of the portfolio.
I use a simple graph to help visualize the diversification benefits of different asset classes, and it's posted at http://www.slideshare.net/casebrad/asset-class-diversification-is-more-…. On the vertical axis I show historical risk-adjusted returns (Sharpe ratio), and on the horizontal axis I show correlation with the broad U.S. stock market--making the assumption that the foundation of your portfolio is your allocation to U.S. equities. What the graph shows is that, while diversification into non-U.S. stock markets has benefited investors through low correlations, diversification into the real estate asset class--even domestically, through U.S. REITs--has provided BOTH low correlation AND strong historical risk-adjusted returns.
Of course, as you point out, the recent past (my analysis covers nearly 25 years) has been especially good for U.S. stocks and especially bad for non-U.S. stocks, and the future may be different. And of course my analysis doesn't mean you shouldn't have BOTH asset class diversification AND global diversification within a given asset class--in general, it seems likely that investors would benefit from both. But my analysis does suggest that asset class diversification (adding REITs to your stocks) is more important than geographic diversification (adding non-U.S. stocks to your U.S. stocks).
Thanks for posting such a good article.