tionally believe that returns are higher in their country relative to the rest of the
world? The answer is yes!
If governments tax foreign investments at rates very different from domestic in-
vestments, then the pattern just discussed would be possible for aftertax returns. Dif-
ferential taxation has occurred in the past, continues to occur today, and will likely
persist into the future.^9 Second, many countries impose a withholding tax on divi-
dends. Taxable investors may receive a domestic credit for the foreign tax withheld
and thus not have lowered returns. However, for nontaxable investors (or for a non-
taxable part of an investor’s portfolio such as pension assets), the withholding is a
cost that lowers the return of foreign investment. A third situation that could cause
foreign investments to have a lower return than domestic investments for all in-
vestors is if there were differential transaction costs for domestic and foreign pur-
chases. This could occur if there was difficulty in purchasing foreign securities or
currency controls existed. For example, there may be restrictions in converting do-
mestic to foreign currency that could affect returns. The exchange of currency A for
B might take place at an official rate higher than the free market rate, and there might
be an expectation of a later reversal. A fourth situation that can result in investors in
all countries having an expectation of higher returns from domestic investments rel-
ative to foreign, is a danger of a government restricting the ability of foreigners to
withdraw funds. Governments can and do place such restrictions on foreigners, and
this can reduce returns to foreigners. The considerations just discussed are real and
can affect the returns from international diversification.
Before leaving this section, one other issue needs to be discussed. It has been sug-
gested that investors could confine themselves to a national market and receive most
of the benefits of international diversification by purchasing stocks in multinational
corporations. Jacquillat and Solnik (1978) have tested this for the American investor.
They found that stock prices of multinational firms do not seem to be affected by for-
eign factors and behave much like the stocks of domestic firms. The American in-
vestor cannot gain much of the advantage of international diversification by invest-
ing in the securities of the multinational firm.
11.8 OTHER EVIDENCE ON INTERNATIONALLY DIVERSIFIED PORTFOLIOS. In
prior sections we have presented the considerations that are important in deciding on
the reasonableness of international diversification. Obviously, we feel that the type of
analysis we have presented is the relevant way to analyze the problem. However, sev-
eral studies analyze the reasonableness of international diversification by examining
the characteristics of international portfolios selected using historical data. The most
common approach attempts to show the advantages of international diversification by
forming an optimal portfolio of international and domestic securities using historical
data and comparing the return to an exclusively domestically held portfolio over the
same time period. It should not surprise the reader that knowing the exact values of
mean returns, variance, and covariances for international markets allows construction
of portfolios that dominate investment exclusively in the domestic portfolio. A vari-
ant of this analysis presents the efficient frontier using historical data with and with-
out international securities and “shows” that adding international securities improves
the efficient frontier.
11 • 18 INTERNATIONAL DIVERSIFICATION(^9) A government’s ability to enforce payment of taxes may be lower on foreign than domestic securi-
ties. Tax cheating could mitigate tax rate differentials.