Risk and Return 69RISK AND RETURN: THE INTERNATIONAL EVIDENCE
Financial markets around the world can be broadly classified as developed or emerging. Emerging markets
typically yield higher returns, but their standard deviation is higher as well. Exhibit 3.10 presents the mean
returns and standard deviation of returns around the world. International investors have the option of investing
in securities from around the world. A major argument for investing internationally is that it increases profit
opportunities while providing risk diversification. Just as investors can diversify away unsystematic risk by
holding a portfolio of stocks, they may also benefit from international diversification. As long as there are
benefits from international diversification, a portion of what seems to be systematic risk in a domestic
context may be diversifiable country risk at a global level. If markets are completely integrated there would
be no benefit from international diversification. Although the tendency of markets to move together has
increased in the recent years, the correlation is still less than 1 (Exhibit 3.11). So there are still opportunities
to reduce risk. In other words, portfolios may be formed out of stocks from many countries to reduce risk
further. As an assignment construct an equal value weighted portfolio of Japan and Germany.
Markowitz Model
Modern portfolio theory is based on the premise that an investor chooses from all possible investments on
the basis of expected portfolio return and portfolio variance. If an investor is rational, s/he will choose that
investment which provides the highest return for a given level of risk or the least risky investment for a given
level of return. Thus, these efficient portfolios dominate other combinations. The curved line that connects
all the efficient portfolios is called efficient frontier. Exhibit 3.12 depicts an efficient frontier.
Exhibit 3.10 Characteristics of emerging and developed markets
Market cap $ m Standard Mean return
Country Sep 1995 deviation (percent) annualized (percent)
Emerging markets
Argentina 18,783 93.1 42.0
Brazil 106,821 64 33.1
Colombia 9,079 31.4 39.7
India 66,772 29.5 17.4
Indonesia 26,995 30.8 3.3
Mexico 65,585 46.5 20.8
The Philippines 32,829 37.4 42.9
Developed markets
Australia 137,352 26.6 15.1
Canada 193,156 19.6 9.7
Germany 344,087 22.4 14.1
Japan 2,050,510 25.1 17.8
Switzerland 285,171 19.2 14.2
UK 842,965 21.5 16.4
US 3,540,304 15.0 14.8
Source: Erb et al. (1996).