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International Diversification and the Home Bias Puzzle

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Introduction

International Diversification and the Home Bias Puzzle The idea behind international diversification is that by adding foreign assets to a domestic portfolio, investors reduce portfolio-level volatility and, thereby, generate better risk-adjusted returns. In any given period, portfolio returns in international markets may be higher or lower than returns generated in an investor's domestic market. However, over long holding periods international diversification seems to have delivered on the promise of reducing portfolio volatility and enhancing risk-adjusted returns. Although international diversification is thought to reduce the volatility of returns, it is not actively pursued by many investors. The first argument put forward against international diversification is that there is increasing correlations in the stock markets around the world. While correlations change over time as the markets become more integrated the correlation between markets will increase. There is empirical evidence showing that stock markets tend to move together in the long run and it seems that stock markets take a long time to adjust to this long run. Garrett and Spyrou (1999) investigate the existence of common trends in the increasingly important emerging equity markets of the Latin American and Asia-Pacific regions. ...read more.

Middle

This means that industries are imperfectly correlated across countries. Therefore if investors undertake international diversification they are benefiting from industrial diversification. However Heston and Rouwenhurst (1995) find that the benefits from international diversification are mainly from geographical diversification rather than from industrial diversification. Griffin and Karolyi (1998) also find that industrial structure explains very little of the cross-sectional difference in country return volatility, and that the low correlation between country indices is almost completely due to country-specific sources of return variation. Diversification across countries within an industry is a much more effective tool for risk reduction than industry diversification within a country. The second reason offered as to why the correlation between international stock markets is so low is that differences in the institutional and legal frameworks, fiscal and monetary policy and so on give rise to large country-specific variations in returns. As mentioned above Griffin and Korolyi (1998) find that country specific components dominate industry effects. It has been suggested that as Europe integrates its fiscal policy and heads towards the Euro that these country specific factors will become extinct. However this does not seem the case at the moment as there is persistent flouting of the rules by large member states such as Germany and France. ...read more.

Conclusion

For example, investing in a foreign company that was not cross listed would require the investor to research the company as to whether it was a suitable company to invest in and what the accounting practices of the country were. This could be costly. Adjusting formula (1) to show this: assume there is a constant proportional fee (representing such things as taxes and costs) on foreign equity: The higher ? the higher the costs and as a result the less attractive foreign equity is. The final explanation offered to explain the home bias puzzle is the one of behavioural explanations. It is suggested that investors are more optimistic about their own markets than foreign markets. Strong and Xu (2003) use the Merrill-Lynch survey of fund managers and focus on fund managers in the US, UK, Japan and Continental Europe. They find that fund managers are relatively more optimistic about the domestic equity market. On average 52% of US managers are bullish about US equities while 63%, 53% and 54% of UK, European and Japanese fund managers respectively are bearish about US equities. Overall it is hard to find one reason that will explain the home equity bias and despite several explanations being given it remains a mystery why risk averse investors fail to diversify their portfolios internationally. ...read more.

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