International Diversification

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  • Topic: Investment, Modern portfolio theory, Risk
  • Pages : 6 (2053 words )
  • Download(s) : 261
  • Published : May 3, 2010
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Introduction
Diversification is a method of investing that been shown to increase portfolio return while reducing portfolio risk as measured by standard deviation. This method specifically increases the efficient frontier for investors. The challenge to an investing firm is an appetite by its customers for an ever increasing efficient frontier. One area to explore to obtain this increase is through further diversifying through international diversification. International portfolio diversification gives your investments a passport to added diversification benefits. The international boundaries to investing have collapsed. Fairly recently, foreign securities have become easier to trade due to improved communications and data technology. Worldwide investors have been realizing that there are substantial gains to be made by investing internationally. International portfolio diversification is portfolio investing in other nations whose economic cycles are not perfectly in phase, in an attempt to reduce risk, measured by portfolio standard deviation. The success of international portfolio diversification depends on low correlations of returns between countries. Investing in a country with an economic cycle that closely matches or exactly matches the economic cycle in the investor’s home country will offer little or no diversification benefits. What is meant by a diversification benefit is a reduction of portfolio risk when an asset is added to a portfolio. The same principles that go along with domestic portfolio diversification can be applied worldwide. Opening the gates of an investor’s portfolio to the world offers the investor several advantages. The benefits include: a world focus; broad diversification; and low correlations. These advantages will lead the investor to have greater success in achieving his financial goals. By investing internationally, an investor will realize that he now has a world focus. More than half of the world’s stock market capitalization is in non-US companies. By only having a domestic focus, an investor loses sight of the investment opportunities that can be realized overseas. International investment also brings a broader range of investments for diversification. By increasing the number of assets available to invest in, international diversification can lessen risks and produce more stable returns. New assets available to invest in could range from a foreign company’s stock to a foreign country’s currency. The potential for a diversification benefit exists in all foreign investments. This potential should not be ignored. {draw:frame} The potential is even greater due to the low correlations that can be found internationally. Returns from different national markets have relatively lower correlation than the domestic market. The lower these correlations are, the greater the diversification benefit will be. The reason that international diversification is beneficial is that individual markets have unsystematic risk. This unsystematic risk can be diversified away by adding international assets. This risk is due to risk that results from uncontrollable or random events that are country specific. According to Solnik, 1974, internationally diversified portfolios can have as little as 11.7% of the risk of individual securities. The underlying reason for added risk reduction from international diversification is that world markets fluctuate differently than our own. Other nations’ economic cycles are not always in phase. This translates to low correlations which can reduce variability in portfolio returns. The different fluctuations can be caused by various factors. These factors include differences in: monetary policies; fiscal policies; industrialization; technology; laws; economic shocks; and other factors. {draw:frame} International diversification pushes out the efficient frontier. Risk is reduced for any given level of return, and return is enhanced for any given level of risk....
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