11 • 1

CHAPTER

11

INTERNATIONAL DIVERSIFICATION

Edwin J. Elton

New York University

Martin J. Gruber

New York University

CONTENTS

11.1 Introduction 1
11.2 World Portfolio 2
11.3 Calculating the Return on
Foreign Investments 3
11.4 Risk of Foreign Securities 6
11.5 Returns from International
Diversification 11
11.6 Effect of Exchange Risk 13
11.7 Return Expectations and
Portfolio Performance 15

11.8 Other Evidence on

Internationally Diversified

Portfolios 18

11.9 Models for Managing

International Portfolios 21

11.10 Conclusion 25

SOURCES AND SUGGESTED

REFERENCES 25

11.1 INTRODUCTION. Portfolio managers in France, Germany, and England have
for decades routinely invested a large fraction of their portfolio in securities that were
issued in other countries. In contrast only in the last decade has there been a signifi-
cant amount of foreign securities held by U.S. investors. Was the historical emphasis
on U.S. securities by U.S. investors provincialism that is now disappearing, or are
there sound economic reasons for the historical differences in the behavior of man-
agers in different countries and for the current changes on the part of U.S. managers?
In this chapter we attempt to present sufficient evidence for the readers to decide for
themselves.
In section 11.2 we examine the market value of equities and debt worldwide. It
turns out that no country comprises most of the world’s wealth. Given the great num-
ber of opportunities worldwide, we discuss whether international diversification is a
sensible strategy for investors. To analyze this question, we first show how returns on
foreign assets are computed. The reasonableness of international diversification de-
pends on the correlation coefficient across markets, the risk of each market, and the

This chapter is based on Chapter 12 of Elton, Edwin J., Gruber, Martin J., Brown, Stephen, and Goetz-
man, William, Modern Portfolio Theory and Investment Analysis, 6th ed., Copyright © 2002, John Wiley
and Sons. This material is used by permission of John Wiley & Sons, Inc.