Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890–2001

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Using a new data set on capital account openness, we investigate why equity return correlations changed over the last century. On the basis of a new, long‐run data set on capital account regulations in a group of 16 countries over the period 1890–2001, we show that correlations increase as financial markets are liberalized. These findings are robust to controlling for both the Forbes‐Rigobon bias and global averages in equity return correlations. We test the robustness of our conclusions and show that greater synchronization of fundamentals is not the main cause of increasing correlations. These results imply that the home bias puzzle may be smaller than traditionally claimed.