122 CHAPTER 3 Risk and Return
The Benefits of Diversifying Overseas
The size of the global stock market has grown steadily over
the last several decades, and it passed the $15 trillion mark
during 1995. U.S. stocks account for approximately 41 per-
cent of this total, whereas the Japanese and European mar-
kets constitute roughly 25 and 26 percent, respectively. The
rest of the world makes up the remaining 8 percent. Al-
though the U.S. equity market has long been the world’s
biggest, its share of the world total has decreased over time.
The expanding universe of securities available interna-
tionally suggests the possibility of achieving a better risk-
return trade-off than could be obtained by investing solely in
U.S. securities. So, investing overseas might lower risk and
simultaneously increase expected returns. The potential
benefits of diversification are due to the facts that the corre-
lation between the returns on U.S. and international securi-
ties is fairly low, and returns in developing nations are often
quite high.
Figure 3-8, presented earlier, demonstrated that an in-
vestor can significantly reduce the risk of his or her portfolio
by holding a large number of stocks. The figure accompany-
ing this box suggests that investors may be able to reduce
risk even further by holding a large portfolio of stocks from
all around the world, given the fact that the returns of do-
mestic and international stocks are not perfectly correlated.
Despite the apparent benefits from investing overseas,
the typical U.S. investor still dedicates less than 10 percent
of his or her portfolio to foreign stocks—even though for-
eign stocks represent roughly 60 percent of the worldwide
equity market. Researchers and practitioners alike have
struggled to understand this reluctance to invest overseas.
One explanation is that investors prefer domestic stocks be-
cause they have lower transaction costs. However, this expla-
nation is not completely convincing, given that recent stud-
ies have found that investors buy and sell their overseas
stocks more frequently than they trade their domestic
stocks. Other explanations for the domestic bias focus on the
additional risks from investing overseas (for example, ex-
change rate risk) or suggest that the typical U.S. investor is
uninformed about international investments and/or views
international investments as being extremely risky or uncer-
tain. More recently, other analysts have argued that as world
capital markets have become more integrated, the correla-
tion of returns between different countries has increased,
and hence the benefits from international diversification
have declined. A third explanation is that U.S. corporations
are themselves investing more internationally, hence U.S.
investors are de facto obtaining international diversification.
Whatever the reason for the general reluctance to hold
international assets, it is a safe bet that in the years ahead
U.S. investors will shift more and more of their assets to
overseas investments.
Source:Kenneth Kasa, “Measuring the Gains from International Portfolio
Diversification,” Federal Reserve Bank of San Francisco Weekly Letter,Number
94-14, April 8, 1994.
U.S. Stocks
U.S. and International Stocks
Number of Stocks
in the Portfolio
Portfolio Risk, σp
(%)
120 Risk and Return
