The world has seen tremendous capital market integration globally and inclusion of international securities in the portfolio has been well documented by both the academicians and practitioners worldwide. Initially, Grubel (1968) conceptualized the modern portfolio analysis which was pioneered by Markowitz (1952) and Tobin (1958). The rationale of the theory was that international diversification is achieved with the help of the movement of different international factor movements. The portfolio theory further states that investors can benefit significantly with reducing risk and enhancing returns by venturing out of the home markets. There are imperfect correlations between home market and international markets.
International markets are very closely linked and the rally in one market has an impact on the other market and vice versa. To take an example, the 9/11 US Attacks led to turmoil in the US Market and with it global markets including Tokyo, Hong Kong, Paris, London, Amsterdam had fallen sharply (Landler, 2002).
International diversification has been a financial strategy which helps to reduce the impact of risk on the investment portfolio since different nations and geographies have imperfectly correlated asset returns. For many investors worldwide, international diversification is the appropriate strategy to ensure that both debt and equity in the form of stock and bonds are covered in the investment allocation. Globally the market is characterized by several class of assets and other cross border holdings and investment along with structured products (Lane and Milesi-Ferretti, 2005).
1.2 Rationale of International Diversification
International Diversification will mean addition of international securities in the total portfolio of the investor. Several researchers around the world have shown that movement in asset classes in one country are totally unrelated with the movement in other country. So for example changes in the stock price on Chinese market is independent and any fluctuation would not directly impact the movement in prices on the other stock exchanges. When securities of one country are not performing as well as expected and securities in international markets are doing better, the losses automatically get offset.
The prime motive of having a widespread portfolio is to reduce the impact of risk. Theoretically, the higher the number of asset classes and different types of securities present in the portfolio, the lesser the chances of portfolio getting collapsed. However the total risk in the portfolio is not only limited to the number of securities available in the portfolio but also on the riskiness of the individual asset class. The essay seeks to find out how effective diversification is, in reducing the risk and variability of the portfolio. Diversification will be better if trading takes place on a number of securities on an international scale. The discussion of the essay will be on how effective international portfolio diversification is compared to domestic portfolio diversification.
1.3 Empirical Literature and Studies on International Portfolio Diversification
Levy and Sarnat (1970), Lessard (1973) and Errunza (1977) have conducted many studies on international portfolio diversification. The end of the debt crisis and the growing role of emerging markets have attracted lot of foreign eyes on investing in these countries where returns are expected to soar. Other than emerging economies, researchers like Harvey (1995), Sappenfield and Spiedell (1992) have also highlighted the role of developing nations in giving higher returns to investors worldwide. Investment in developed markets and emerging markets can be differentiated by the regulatory framework, investment regulation and government policies. Emerging markets are characterized by higher volatility, higher returns and low correlations between the developed markets and the emerging ones (Bekaert, Erb, Harvey and Viskanta (1996). The low correlations between developed markets and emerging markets have led investors to change their portfolio and move towards emerging markets (Harvey, 1995).
The role of international diversification is considered because it acts as a vehicle to improve the performance of the portfolio as a whole (Arouri, 2004). Much of the global investment is now being directed towards countries that are adopting liberalized steps and are fundamentally strong (Arouri, 2004). The importance of portfolio diversification beyond domestic frontiers is that it offers potential gains which are far superior than those available with domestic securities (Butler and Joaquin (2001). Moreover investment on an international scale also offers investors with higher number of options for making investment into different set of asset classes than those available domestically (Butler and Joaquin, 2001). Smaller and less developed nations are often not an open economy and their investment pattern is domestically attributed. The government policies of these nations are such that the investment is made only in home traded assets (IMF, 2001). However lot of countries have liberalized their policies and opened the doors for investment leading to higher global market integration.
Stulz (1984) referred that international portfolio diversification is the result of less financial assets available domestically and the inappropriate risk and return profile in which the investor operates. Study conducted by Grauer and Hakanson (1987) with the use of multi-period model found that gains were higher in case of investors who had an international diversification of financial assets. Eun and Resnick (1994) conducted a study on international portfolio diversification and found that benefits of international portfolio diversification were related to exchange rate fluctuations and uncertainties in cross currency movement. Study conducted by Glen and Jorion (1993) with the use of long term fixed investment and bonds and other equity related risky assets found that there were improved gains in investors international portfolio because of the hedging which was available to investors as a result of the international exposure.
Froot (2001) further used factors like exchange rate, foreign risk, and foreign inflation with a cross country variation analysis and found that investors prefer investing in a portfolio which is internationally spread and can lead to a better risk and return trade off. Das and Uppal (2002) with the use of a multivariate model found that international portfolio diversification led to a highly infrequent correlation among different set of financial assets.
The puzzle and phenomenon of Home-Bias was studied by French and Poterba (1991) found that it was difficult to understand investors since they are divergent to the home based investment culture. Stulz (1994) states that 'Home Bias' is the biggest deterrent to the growth of international portfolio investment and diversification. French and Poterba (1991) further also studied the cost of incomplete diversification and found that the home based bias was mainly due to factors like limits and rules set by regulators, investor's behaviour and the expectation from domestic markets and the process of heterogeneity in which they perceive risk.
1.4 Benefits from International Portfolio Investment
Including international securities in the portfolio has several benefits which help makes a perfect portfolio for investors. The advantages of international portfolio diversification drive investors to look for plethora of investment options worldwide. Firstly international portfolio would help investor to participate in the growth and scope of foreign markets. Second, international portfolio diversification would lead to hedging the consumption basket of investors. Third, investors would get abnormal or supernormal returns due to market segmentation. Other than this investor would also get higher expected returns from the diversified portfolio, will reduce the variation in returns and lastly will reduce the correlation of returns from foreign securities of investor's home market. The significant benefit of all the above is the participation of the investor in the growth of other countries rather than only domestic boundaries.
Investors whose portfolio is mostly comprised of domestic securities normally restrict themselves to a large number of financial assets. Since they do not have foreign assets in their portfolio like stocks, bonds and other securities they limit themselves from the power of diversification. Investors who are not internationally integrated and do not have widespread international securities in their portfolio will normally be impacted only by national events like interest rate, monetary policy and other taxation laws.
Any individual must strategically allocate between his current consumption, productive investment and financial investment. Once present consumption and productive investment is made the dilemma occurs for making allocation between financial investments which gives the most desired return which makes future consumption pleasant. The principle of investment theory is to rationally allocate funds between different financial alternatives. Since international theory involves international financial assets and thereby foreign currency which would mean the foreign exchange risk would need to be adjusted for the movement in currency.
1.5 HMD v/s IPD (Home made Diversification versus International Portfolio Diversification)
International Portfolio Diversification (IPD) is the way there is diversity and balance amongst different industrial structures in different countries related to different international and industrial factors (Roll, 1992). According to Ferreira and Gama (2005), "adding international diversification increases the effectiveness of the portfolio and reduces the portfolio risk both locally and globally".
International Portfolio Diversification (IPD) emerges at the local level wherein the returns from international equity markets are correlated. The lower the correlation level, the higher is the returns generated out of IPD and vice-versa. Similarly the higher is the correlation between home-made diversification portfolio and foreign index the stronger will be the ability of the foreign index to derive returns along with domestically traded assets and vice versa. One of the major questions surfacing investors worldwide has been on what is the level of diversification one should enter into? A research was conducted by Campbell and Xu (2000) which was conducted in US and it was found that individual stocks have correlations and go down over time. The conclusion from the study was that reducing correlations between stocks simply led to enhancement in portfolio diversification. According to Bloomfield, Leftwich and Long (1977), 20 stocks in a portfolio helps to achieve total diversification on an international level while Statman (1987) stated that a good internationally diversified portfolio should have at least 30 stocks.
The Capital Asset Pricing Model suggests that investors investing in different countries should ideally invest in nations where the risk and return trade off is characterized in a similar investment which reflects in their appetite to invest among different set of asset classes (Potreba, 1991). According to Poterba (1991) "the ownership of the shares in domestic markets is mostly present in countries like Japan with 95.7%, United States with 93%, France with 90%, Germany with 80% and United Kingdom with 92%". This reflects the home bias which these five countries have towards their investment pattern. Lewis (1999) further states that the investment of investors in domestic markets and equity is irrational. The research on home bias and international portfolio diversification suggests that countries which have shifted above the efficient frontier are the ones which are able to benefit from international diversification (Lewis, 1999).
1.6 Home Bias
Inspite of various benefits of international diversification and theoretical attention, the concept has not been widely embraced worldwide. Investors are mostly tilted towards investing in domestic market where the weight of holding of stocks is heavy domestically. This is known as 'home-bias'. The investors are more loyal towards home markets and local equity and bonds because of the reluctance to venture into international markets which are primarily accompanies by 'hazards' like political risk, economical risk, exchange risk, interest rate risk, investment barriers, information asymmetries and other psychologically related factors. Multinational companies worldwide have been trying to reduce the home bias by listing its subsidiary company on domestic markets which helps investors to have some form of international diversification French and Porteba (1991) and Coval and Moskowitz (1999).
The higher is the firms international involvement, the higher is the exposure of the investors to global shocks (Fatemi, 1984; Brooks and Del Negro, 2006). Many companies globally have been raising equity capital from other countries through the equity route which makes domestic investment in these companies possible. Cross border listings acts as a catalyst in integrating the local markets and global markets (Fernandes, 2005). Cross border listings are normally in the form of 'Depository Rciepts' (Fernandes, 2005). According to Karolyi (1998) and Ennunza et al (1999) "addition of Depository Receipts in domestic portfolios helps to reduce some form of risk"
1.7 Conclusion
The recent decades have been mostly characterized by the shift in the way international markets have behaved. Domestic markets across the world have now become closely integrated with each other and with this there has been a constant rise in the number of cross border transactions. With further reduction in the regulatory and trade issues across nations there has been increased flow of goods, services and movement of people. The increased globalization activity has further led to increase in international financial activity and investment. Further the increased information flow and communication network have made investors have access to international information flow. This has created more investment opportunities for investors across the globe by following the cross globalization phenomenon. Internationally companies have been growing which has led to the demand of funds from both domestic and international markets thus creating the need for raising money through different financial instruments.
There has been an explosive growth in both equity and fixed income market across the world. Different countries have different set of risks and jurisdictions in which they operate which further creates different opportunities for investors to manage and mitigate their risk structure. This paper has discussed about domestic diversification and international diversification with the crux about investors having home bias. Developed nations across the world have far more liberalized policies and can invest in different securities across the world however the developing economies are still opening their markets and it will take time for investors to make investment in international financial assets. However with international portfolio diversification, investors can spread its risk across countries and financial asset products which will be better than investing in the domestic market.
The main question to answer here is about how well an investor can maintain his risk and return portfolio. Investors in modern global market are bombarded with silos of information flow about different countries and the different range of financial assets. Investors who are 'home biased' are mostly related so because of the regulatory issues which inhibits them to invest in international markets. However with growing liberalization and reduction in investment barriers, investors will have access to more and more markets and more investment products which will increase further diversification internationally and ad more international securities in the investors portfolio.
