International Portfolio Diversification
Introduction: -
As the old adage goes “never keep all your eggs in the same basket”; diversification should be the key factor in any investing modus operandi. This statement still holds true today as demonstrated by its empirical validity.
The pioneering theoretical model of portfolio selection developed by Markowitz and Tobin reinforces this statement by providing an argument favouring the diversification of risky assets underlining that the degree to which diversification can reduce risk depends upon the correlations among security returns. Should the returns not be correlated, then diversification could eliminate risk.
It must be pointed out that within an economy; a strong tendency usually exists for economic phenomena to move in conjunction
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His paper demonstrated that the creation of efficient portfolios suggest that despite the fluctuations in the variance-covariance matrixes-variations attributable to the changes in exchange rates, the relative importance of the exchange rate changes does not seem to erode the benefits from international portfolio diversification.
Jorion (1985) in his paper addresses the flaws of the mean-variance model which is used as a platform to advocate international portfolio diversification. He instead proposes the use of the Stein estimator and his results point out that most of diversification benefits are likely to accrue from risk reduction.
Lessard’s (1973) study shows that diversification between developing countries of a single geographical region is possible.
Valadkhani, Chancharat & Harvie (2008) paper shows that geographical proximity and level of economic development do matter when it comes to co-movements of stock returns and has implications on diversification to reduce systematic risk across countries. Thus a shrewd investor should include a range of securities from various continents and from developed as well as developing countries with varying degrees of stock market
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The first paper’s results substantiates that international portfolio diversification is not limited to only developed markets but should also include securities from the least developing countries as well. Problems and additional costs associated with such investments do not outweigh its benefits. The second paper showed that even after accounting for foreign currency fluctuations, the gains achieved from international diversification are not completely annihilated. Such results also confirm that developing countries are on average much less integrated in world financial
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