Fundamentals of Financial Management (Concise 6th Edition)

250 Part 3 Financial Assets

The increasing availability of international securities is mak-

ing it possible to achieve a better risk-return trade-o" than

could be obtained by investing only in U.S. securities. So

investing overseas might result in a portfolio with less risk

but a higher expected return. This result occurs because of

low correlations between the returns on U.S. and interna-

tional securities, along with potentially high returns on over-

seas stocks.

Figure 8-6, presented earlier, demonstrated that an

investor can reduce the risk of his or her portfolio by holding

a number of stocks. The # gure that follows suggests that

investors may be able to reduce risk even further by holding

a portfolio of stocks from all around the world, given the fact

that the returns on domestic and international stocks are not

perfectly correlated.

Even though foreign stocks represent roughly 60% of

the worldwide equity market and despite the apparent ben-

e# ts from investing overseas, the typical U.S. investor still

puts less than 10% of his or her money in foreign stocks. One

possible explanation for this reluctance to invest overseas is

that investors prefer domestic stocks because of lower trans-

actions costs. However, this explanation is questionable

because recent studies reveal that investors buy and sell

overseas stocks more frequently than they trade their domes-

tic stocks. Other explanations for the domestic bias include

the additional risks from investing overseas (for example,

exchange rate risk) and the fact that the typical U.S. investor

is uninformed about international investments and/or thinks

that international investments are extremely risky. It has

been argued that world capital markets have become more

integrated, causing the correlation of returns between di" er-

ent countries to increase, which reduces the bene# ts from

international diversi# cation. In addition, U.S. corporations

are investing more internationally, providing U.S. investors

with international diversi# cation even if they purchase only

U.S. stocks.

Whatever the reason for their relatively small holdings

of international assets, our guess is that in the future U.S.

investors will shift more of their assets to overseas

investments.

Source: For further reading, see also Kenneth Kasa, “Measuring the Gains from International Portfolio Diversi# cation,” Federal Reserve Bank

of San Francisco Weekly Letter, Number 94–14, April 8, 1994.

THE BENEFITS OF DIVERSIFYING OVERSEAS

U.S. Stocks

U.S. and International Stocks

Number of Stocks

in the Portfolio

Portfolio Risk, σp

(%)