Consider an investor has an exposure to one asset class, such as to UK Equities. The earnings of the investor will fluctuate completely with that for UK Equities. But if the investor diversifies to also hold UK Gilts, some of the risks embedded in this portfolio can be removed without impacting on returns, since one performs strongly while the other may not. Take the equity market crash in the October 1987 as an example, UK Equities declined 27% for the month while UK Gilts increased by approximately 6%. In this situation, the security specific risks can be eliminated to a certain extent by gaining an exposure to other asset classes. (Frontier Capital Management, January 2009)
The key benefits of diversification are reducing portfolio loss and volatility, which are documented in both academics and practice. The Modern Portfolio Theory suggests that to obtain diversification benefits, the feasible correlation range should be between [-1, 1). By holding assets not perfectly correlated (ρ≠1), that is, do not move in perfectly same direction, the risks in a portfolio can be lowered and higher risk-adjusted returns can be achieved. In other words, the lower the correlation between assets, the greater the risk reduction can be obtained. Market Portfolio, a properly diversified portfolio reduces the all diversifiable risk to the level of non-diversifiable risk, through combination of all assets classes that generate the highest risk adjusted returns. This portfolio suggests diversifying as much as possible amongst uncorrelated assets, not to be restricted to one country but including all asset classes globally.
Early studies by Grubel (1968), Levy and Sarnat (1970) believed there are low correlations between index returns in different countries and argued the benefits of international diversification outweigh the huge costs, including transaction costs, regulatory and cultural differences, exchange rate risks. Since the foreign investments incline to be less closely correlated with domestic investments, diversification benefits could be obtained. For example, an economic downturn in the U.S. may not affect Japan's economy in the same way, which allows a U.S investor to have a small cushion of protection from Japanese investments against losses from the U.S. economic downturn (need some figures to prove?). Recent evidence has shown that international diversification benefits are small for U.S. investors once transaction costs and short-sales constraints are incorporated (DeRoon, Nijman, and Werkerhenceforth, 2001). However, for investors in small, developing countries, global diversification may be much more important than for U.S. investors.
Washington University Theory suggests and results show that firm performance is at the beginning positive but eventually diminishes and becomes negative as international diversification enhances. The product diversification mitigates the connection between international diversification and performance. International diversification is negatively related to performance in non-diversified firms, positively related in highly product-diversified firms, and curvilinearly related in sparingly product-diversified firms. International diversification is also positively related to intensity, but the interaction effects with product diversification are negative. The results of this study provide evidence of the importance of international diversification for competitive advantage but also suggest the complexities of implementing it to achieve these advantages
US and other investors start investing in foreign securities markets. Global markets have become more incorporated, these may occur the broad tendency toward liberalization and deregulation in the money and the capital markets of developing countries. These modifies has as a result greater correlation between national stock markets (decreased profits from international diversification). This may lead to future gain at the emerging markets of Asia and Latin America. Nowadays they are looking to invest in emerging markets with promising international diversifications such as those of Central Europe.
According to the modern portfolio theory, the benefits of international portfolio divaersificationa connected with the correlations of security returns. The advantages of international diversification come up from the low correlations among developed and emerging equity markets have been confirmed in a number of studies such as Eun and Resnick (1984), Errunza and Padmanabhan(1988), Wheatly (1988), Meric and Meric (1989), Bailey and Stulz (1990), Divecha et al. (1992) and Michaud et al. (1996). However, several recent studies, such as those of Roll (1988), Hamao et al. (1990), Lau and McInish (1993), Rahman and Yung(1994), and Meric and Meric (1997), certificate an important augmentation in correlations and volatility transmission between equity markets during and after, the 1987 international equity market crash.
A common feature of the above studies is that correlations between equity markets were estimated using relatively short-term horizons (weekly, monthly or quarterly). Kasa in 1992 mentioned that the benefits from international diversification affected by low correlations may be a misleading result for investors with long-term investment horizons if equity markets are trending together. Therefore, many current studies have used a combination of techniques to investigate whether there is any link and long-term actions between both developed and emerging equity markets. These examinations have created varied results and conclusions to the expenditure from diversification for US investors.
Investigating long-term connections between the US and European equity markets,
Kasa (1992) and Arshanapalli and Doukas (1993) generated confirmations of connections between the US with those markets; although , the results in Byers and Peel
(1993) and Kanas (1998) recommend that there is no such connection. Diversity in time
periods looked at and in research methods applied may explain the difference of outcomes between these studies. Studies of developed markets in the Pacific area have also created diverse findings. Campbell and Hamao (1992) argue that the US and Japanese markets are extremely incorporated, while results by Harvey (1991) and Chan et al. (1992) pointed out a lack of unification between the US and Asian markets. Sewell et al. (1996) present confirmation of varying integration between Pacific Rim equity markets and the US.
DeFusco et al. (1996) report that the US market is not united with thirteen emerging capital markets in three geographical regions the Pacific Basin, Latin America and the Mediterranean. Felix et al. (1998) find no progress between the US and a number
of developing markets. The noticeable autonomy of the US and emerging markets recommend the existence of long-term benefits from diversification across these
countries.
