Benefits of International Portfolio Diversification

https://gbr.pepperdine.edu/2010/08/benefits-of-internationalportfolio-diversification/
Findings indicate that co-movements among the U.S., Germany, and Japan
markets are significant.
By Burhan F. Yavas, PhD
2007 Volume 10 Issue 2
It is well known that stock market investing is risky. Both practitioners and theoreticians
recommend holding a well-diversified portfolio to reduce risk. While mutual funds offer a quick
and relatively inexpensive way to diversify, the purpose of this article is to address the issue of
risk reduction through international diversification.[1] The article also provides support for the
hypothesis that international market correlations increase after unexpected exogenous shocks.
The implication is that diversification benefits may be reduced after such events. The tests of
stability of market co-movements are based on before and after analyses of the September 11,
2001, terrorist events in the United States.
The paper considers an important problem that may interest retail and institutional investors,
portfolio managers, corporate executives and policy makers. Knowing the correlations between
the returns of various national markets is important for the process of allocating investments
among these markets.
All of the major U.S. indices ended the year 2006 having logged double-digit gains. However,
even though Standard & Poors 500 index turned in a 13.6 percent performance, an investor
would have done better had he or she ventured outside the U.S. Using averages, domestic stock
funds gained 12.6 percent in 2006 compared to 25.5 percent for international stock funds
Not surprisingly, Charles Schwab, a leading U.S.-based broker, recommends that its customers
rebalance their portfolios in favor of foreign equities.[2] Many other financial advisors are also
advising their clients to consider investment opportunities in overseas markets. While these
recommendations by brokers may be specific to the current market conditions, globalization
aided by advances in communication technology, abolition of capital and exchange controls, and
deregulation in recent years, seem to have increased access to foreign markets.
CAPM and MPT Theories of Finance

Two well-known theories in the finance literature, the Capital Asset Pricing Model (CAPM) and
the Modern Portfolio Theory (MPT), suggest that individual and institutional investors should

hold a well-diversified portfolio to reduce risk. An institutional investor can achieve a welldiversified portfolio because the amount of funds in the portfolio is large enough for in-house
diversification. Individual investors with limited wealth will have to find another way that does
not require substantial funds to diversify their portfolios. Mutual funds offer a quick and
relatively inexpensive way to diversify for small investors and others.
It is also argued that since differences exist in levels of economic growth and timing of business
cycles among various countries, international portfolio diversification can be used as a means of
reducing risk. In fact, the 1990s witnessed an explosion of international portfolio investment,
especially among emerging markets. Mutual fund companies such as Janus and Templeton
achieved phenomenal rates of return on their investments during the mid to late 1990s. It should
be made clear that while performances of these mutual funds over the long haul vary, it is still
true that diversification reduces risk at a given level of return.
Market Integration Influences

National economies have recently become more closely linked, not only because of growing
international trade and investment flows, but also due to terms of international financial
transactions. Influences contributing to an increased general level of correlation among markets
and markets integration include the following:
1. Development of global and multinational companies and organizations,
2. Advances in information technology,
3. Deregulation of the financial systems of the major industrialized countries,
4. Explosive growth in international capital flows, and
5. Abolishment of foreign exchange controls.

While some controversy exists among investment professionals regarding the benefits and costs
of international portfolio investment, there is agreement that international equity portfolio
diversification recommendations are based on the existence of low correlations among national
stock markets.
On the other hand, if it is true, as some recent studies have shown, that cross-country correlation
is increasing, due perhaps to the growing interdependence among the international markets, then
benefits of international portfolio diversification may be overstated. In this article we aim to shed
light on international equity market interdependence by utilizing data from three major equity
markets for a relatively short time period. In examining the co-movements of American,
Japanese, and German equity markets, we seek to identify diversification opportunities for

international investors with the aim of lowering the investment risk. We also investigate the
stability of the relationships among the markets after an unexpected, exogenous event.
Research on Markets

Research reveals that stock markets across the world are becoming more integrated. Madura
found that correlations markedly increased over time.[3] Forbes and Rigobon tested the stock
market contagion during the 1997 East Asian crisis, the 1994 Mexican Peso collapse, and the
1987 U.S. stock market crash.[4]
Research on the stability of market integration, on the other hand, indicates that volatility affects
cross market correlations. Interested readers should consult Longin and Solnik[5] and Meric and
Meric.[6] Their results indicate that the co-movements of equity markets increased significantly
after the crash, implying that the benefits of international diversification decreased considerably.
Data and Methodology

We use the daily closing values of the Standard & Poors 500 Index (S&P 500), the Nikkei 225
Index, and the DAX 30 to represent the respective stock markets of the U.S., Japan, and
Germany during the period of January 4, 1999 to February 28, 2002.
First, we examine trading in Japan, followed by the opening of the markets in Germany after the
close of the Japanese market. The German market has a one-hour overlap with the U.S. stock
market. Therefore, global information is already incorporated in the non-U.S. markets prior to
the opening of the U.S. market. However, the developments in Germany and in the U.S. are not
reflected in Japan until the following day.
We next focus our attention on the influence of the German market on that of the U.S. We close
the loop by studying lagged correlations in terms of the U.S. markets influence on Japan and
Germany.
Findings and Results

A simple analysis of data indicates that during the study period (January 1999 to February 2002),
the three markets moved in tandem 30 percent of the days (15.7 percent positive and 14.3 percent
negative). American and German markets moved concurrently 47.4 percent of the time, and
Japanese and German markets moved in the same direction 43.3 percent of the time. Finally, the
U.S. and Japanese markets moved together 54.2 percent of the time (See table 1).

After observing the market co-movements in the same or in different directions, we calculate
both auto and cross-correlations and conduct tests on the hypotheses to study whether they are
statistically significant. If they are significant (that is, significantly different from zero) this will
point to the direction of close correlation among the markets, a finding which implies diminished
diversification benefits for investors. If, on the other hand, correlations are insignificant (not
significantly different from zero), investors can benefit from international diversification.
The results indicate that the Unidirectional Moving Correlation Coefficients (UMCC) of NIKt
and DAXt are not significantly different from zero (Table 2). In plain terms, Japanese and
German markets are not correlated. The implication is that both Japanese and German investors
can realize diversification benefits by investing in each others markets. We also note that the
UMCC of Japan and the U.S. is likewise insignificant, implying that the American and Japanese
investors may lower investment risk by investing in each others markets, however, we also note
that correlation coefficients have been increasing since the year 2000, indicating growing
interdependence between the U.S. and the Japanese markets.

Looking at correlations between the German and the U.S. markets, we note that the correlations
are significantly different from zero and show an increasing trend, a finding that implies that the
co-movement (or interdependence) of the two markets has increased over time. Therefore, from
the perspective of the international investor, these results imply that the benefits of international
portfolio diversification across the U.S. and Germany are possibly becoming less significant.
Nevertheless, it may be noted that the existence of past correlations does not guarantee that such
correlations will exist for any future period.
It is also interesting to note that since correlation coefficients are unidirectional, correlations
going from the U.S. to Japan are not the same as those going in the opposite direction. This is
due to the fact that trading hours of the markets are different and that the market that opens later
typically contains information on what happened in the market or markets that had already
closed.
For example, we found the median correlation coefficient moving from the U.S. to Japan to be
equal to 0.347, while the mean UMCC from Japan to U.S. is only .138. This result may indicate
that the Nikkei 225 returns are much more correlated with the S&P 500 returns after the close of
the U.S. market than would be the reverse case.
Similar results were found between the U.S. and the German markets where mean UMCCs were
higher in the direction from Germany to the U.S. than they were from the U.S. to Germany. This
result again reflects the availability of information in the German market that opens well before
trading in the U.S. begins.
In conclusion, international diversification will result in risk reduction for a given return as long
as the correlation coefficient between the domestic and the foreign market is less than one (i.e.,
less than 100 percent). Lower future correlation will provide deeper risk reduction. Based on our
results, a U.S. investor having a portfolio of U.S. stocks will experience a small diversification
benefit (risk reduction) by investing in German stocks since the cross correlation coefficients
with the German market are rather large. On the other hand, the same U.S. investor will have
better diversification benefit by investing in the Japanese market.
The same is true for a German investor. This is so because a Germany-Japan combination will
yield better diversification than will a Germany-U.S. combination. Similarly, investors in Japan
can achieve equally desirable portfolio diversification benefits when they invest in Germany or
the U.S.
Stability of Interdependencies among Markets

Finally, we utilize event methodology to test the hypothesis that correlations among markets are
significantly higher following exogenous events. Longin and Solnik and Karolyi and Stulz[7] are
examples of two of the studies that find that the correlations between the major stock markets
increase after global shocks. To see if data used in this study could provide support for the above
hypothesis, we studied the September 11, 2001, terrorist attacks on the World Trade Center in

New York, the Pentagon in Washington, D.C., and on a plane that crashed in a field in
Pennsylvania.
The 9/11 event is important event to study because the most powerful country in the world was
targeted on its own soil on such a scale that these events shook confidence throughout the entire
global economic system. Following the attack, major world stock market indices declined and
trading was halted in the U.S.
To investigate the effect of the 9/11 attacks on the stability of the interdependence of the markets,
we conducted tests that addressed the question of whether the correlations would remain constant
over the adjacent sub-periods. It is recommended that the sample period before the event should
exceed the sample period after the event.[8] Accordingly, we have chosen sample sizes of six
months before and three months after the September 11 event.
The findings reported in Table 3 following the September 11, 2001 terrorist attacks indicate that
the correlations between Germany and the U.S. increased significantly.

Similarly, the correlations between the Japanese and the U.S. markets increased significantly, but
decreased (not significantly) going the other way. Increased correlations among major equity
markets may reflect the spread of a crisis of confidence within the global investment community.
This result implies that events of September 11 may be interpreted as a global shock affecting
most of the equity markets in the same direction, thereby giving rise to increased correlations
between the U.S. and the Japanese markets and between Germany and the U.S.

Summary and Conclusions

In investigating the short-term co-movements among the U.S. and German stock markets during
1999 to 2002, our analyses supported the findings of the existing literature that the comovements among these two markets were significant and varied over time. The Japanese stock
market, on the other hand, had almost no significant effect on the movement of the other
markets.
Despite the significant interdependencies among the markets studied, room for international
portfolio diversification nevertheless seems possible. In particular, both German and Japanese
investors should consider investing in each others markets for effective portfolio diversification.
Similarly, American investors can realize diversification benefits in Japan. However,
diversification benefits are minimal for American and German investors who would like to invest
in each others markets.
Lately, investors have been venturing into emerging markets; while there has been an increase in
the degree of cyclical co-movement among industrialized countries over time, emerging market
economies are not closely correlated with industrial country markets. In fact, ongoing research
by the present author confirms that investing in emerging countries offers considerable
diversification benefits for international investors.
The September 11 terrorist attacks appear to have had the same effect on the relationship of these
three markets. Correlations between Japanese and the U.S. markets and the German market and
that of the U.S. had both increased. While correlation between German and Japanese markets
increased, the change is not statistically significant. These results indicate that correlations do
increase following exogenous shocks, a finding that confirms earlier results in the literature.
This study demonstrates that it may be possible to reduce the risk associated with stock market
investing for a given level of expected returns by diversifying internationally. However, investors
must be weary of unexpected events such as the terrorist events of 9/11. Based on the results of
this study, increased correlations between international markets indicate that benefits of
international diversification diminish after an unexpected exogenous event.
It is also important to acknowledge that international investing involves currency risk. The
analysis carried out here did not deal with currency risk since fluctuating currency values may
reduce or enhance returns.
It may be argued that international investing is difficult and not practical for most investors since
U.S.-based investors rely primarily on closed-end single country funds and/or international index
funds. Further, market indices may not represent easily investible assets due to high costs and
entry barriers. However, recent introduction of new products such as exchange traded funds
(ETF) have made international investing easer. ETF products track portfolios designed explicitly
to allow internationally comparable benchmark performances yet can be easily traded on

organized exchanges. Therefore, if foreign stock markets continue to outperform the domestic
market along with a favorable economic outlook and easer access, it is likely that foreign
markets will continue to be attractive to U.S. investors in the future.
[1] F. Rezayat, B.F Yavas. International Portfolio Diversification: A Study of Linkages among
the U.S., European and Japanese Equity Markets, Journal of Multinational Financial
Management, 16, no. 4 (2006/10): 440-458.
[2] L. Sonders. Best Ideas for 2007 and Beyond: Be the Smart Money, Charles Schwab & Co.,
Inc., (December 2006).
[3] J. Madura. International Financial Management, 3rd ed, (Minnesota: West Publishing
Company, 1992).
[4] K. Forbes, R. Rigobon. No Contagion, Only Interdependence: Measuring Stock Market CoMovements, (Massachusetts: National Bureau of Economic Research, 1999).
[5] Francois Longin, Bruno Solnik. Is the Correlation in International Equity Returns Constant:
1960-1990? Journal of International Money and Finance, 14, no. 1 (Feb, 1995): 3-26.
[6] G. Meric, I. Meric. Co-movements of European Equity Markets Before and After the 1987
Crash, Multinational Finance Journal, 1, no. 2 (1997): 137-154.
[7] G. Karolyi, R. Stulz. Why Do Markets Move Together? An Investigation of U.S.-Japan
Stock Return Co-movements, Journal of Finance, 51, no. 7, (1996): 951-986.
[8] B.F Yavas, F. Rezayat. Integration among Global Equity Markets: Portfolio Diversification
using Exchange Traded Funds, unpublished manuscript.
About the Author(s)

Burhan F. Yavas, PhD, is an adjunct professor, working as a class advisor for Presidential Key
Executive (PKE) MBA at the Graziadio School of Business and Management. He is also a
professor in accounting and finance at California State University, Dominguez Hills (CSUDH).
He consults for corporations and financial institutions in the areas of export-import management,
market surveys business forecasting, and corporate strategy. He has lectured and written in a
variety of publications, including the Management International Review, Journal of
Multinational Financial Management, International Trade Journal, and Journal of Cross Cultural
Management.
Issue: 2007 Volume 10 Issue 2
Topic: Finance / Investing / Accounting
Tags: diversification, global finance, investments, portfolio management, stock market

Comments

Ken Faulkenberry
September 2, 2011 at 7:11 pm
Interesting finding on international correlations. As global markets mature correlations continue
to become more positive. Yet the explosion of ETFs, including country categories and subcategories is making it easier to further diversify and find non-correlating assets. I have written
an article titled Investment Portfolio Diversification Definition, Examples, & Advantages for
anyone interested at:
http://blog.arborinvestmentplanner.com/2011/05/investment-portfolio-diversification-definitionexamples-&-advantages