NCPA - National Center for Policy Analysis


July 19, 2007

Investors disproportionately weight their asset portfolios toward domestic securities and thus forgo the gains possible through international diversification.  This tendency causes consumers to be underinsured against aggregate shocks that otherwise could have been hedged by holding foreign assets.  In the framework of both macroeconomics and financial economics, the underlying source of diversification arises from the relatively low correlation in asset returns across countries, according to a new study by the National Bureau of Economic Research (NBER).

Author Karen Lewis examines the data on foreign returns from a U.S. investor's point of view to consider the impact of changing co-variances among international returns on the opportunities for diversification.  She finds:

  • Co-variances among country stock markets have indeed shifted over time for a majority of countries.
  • However, in contrast to the common perception that markets have become more integrated over time, the co-variance between foreign markets and the U.S. market has increased only slightly over the last 20 years.
  • Moreover, the standard deviation of the foreign portfolio has declined over this time.

Lewis' analysis points to some general trends in the foreign portfolio diversification potentials.  These trends could be summarized as follows:

  • International equity markets have become more highly correlated.
  • Foreign stocks inside the United States have become more correlated with the U.S. market over time.
  • As a consequence of these trends, the attainable diversification from participating in foreign markets is declining, whether the investor holds foreign stocks inside or outside the United States.

Source:  Les Picker, "The Declining Gain from International Portfolio Diversification," NBER Digest, July 2007; based upon: Karen Lewis, "Is the International Diversification Potential Diminishing? Foreign Equity Inside and Outside the U.S.," National Bureau of Economic Research, Working Paper No. 12697, November 2006.

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