The focus of this paper is to analyze the feasibility of international portfolio diversification for a potential US investor with a moderate risk aversion. The first section includes the benefits of international portfolio investment with a special emphasis on the diversification aspect. The changes in correlations over different periods are discussed and the investments time horizon importance is stressed. The second section presents the additional costs incurred by maintaining an internationally diversified portfolio, including the risks and constraints involved. The conclusion contains a set of recommendations for a potential investor interested in internationally diversifying his portfolio.risks, investments, portofoliom, diversification

Doina Chichernea

English

Research Papers in Economics

International Portfolio Investment 
Doina Chichernea 
MBA – Toledo , Ohio, SUA 
dchichernea@yahoo.com 
Executive Summary 
 
The focus of this paper is to analyze the feasibility of international portfolio diversification for a potential 
US investor with a moderate risk aversion. The first section includes the benefits of international portfolio 
investment with a special emphasis on the diversification aspect. The changes in correlations over 
different periods are discussed and the investments time horizon importance is stressed. The second 
section presents the additional costs incurred by maintaining an internationally diversified portfolio, 
including the risks and constraints involved. The conclusion contains a set of recommendations for a 
potential investor interested in internationally diversifying his portfolio. 
Benefits of International Portfolio Investment 
Investing internationally provides not only increased stability to a portfolio, but also potential higher 
yields with less risk. By investing in foreign securities, investors can participate in the growth of other 
countries and diversify the risk of a potential bearish US market
1. Nevertheless, it is important to notice 
that on the long run international benchmark returns exceeding U.S. equity market returns is not the most 
important benefit of international investing. Actually, over the last 30 years, the Morgan Stanley Capital 
Index Europe, Asia, Far East (MSCI EAFE) has outperformed the S&P 500 by an insignificant amount (a 
little over 1% on average) [1]. Furthermore, a strong U.S. dollar and weaker foreign currencies 
undermined the returns to MSCI EAFE for U.S.-based investors, as illustrated in Figure 1 [2]. 
The most obvious advantage of international investing is the ability to reduce portfolio volatility (see 
Figure 2). The actual benefit derived from international diversification is a function of return correlation 
and volatility. If markets exhibit highly positive correlation, there is little one can do to diversify market 
risk. Correlations between various stock market returns globally are significantly lower than between 
various sectors in the same market [3]. It is important to realize that correlations are not stable over 
different time periods (see Table 1) and maintaining an  international portfolio requires constant 
adjustment as the investment frontier keeps changing for different periods (see figures 2 through 8). 
The increased pace of globalization has made international investments more accessible to general 
investors. Emerging markets in particular have begun to offer attractive investment alternatives as they 
become more and more accessible and they offer higher returns. Less than perfect correlations between 
national economies are also adding the advantage of decreasing risk by diversification. Nevertheless, the 
downside of globalization is that it leads to increased international trade and therefore increased 
correlation between countries’ economies (see Table 2). Yet, investing internationally, especially if done 
so with a long time horizon in mind, is undoubtedly beneficial to investors. 
Holding a well-diversified portfolio of leading global companies based in the United States is not 
sufficient. Companies with significant foreign currency revenue or expenses are concentrated in distinct 
industries and it is difficult to rebalance the sector exposure within an individual company [1]. 
International Diversification Costs 
Even though these advantages appear attractive, the risks and constraints for international portfolio 
investment must not be overlooked since they might influence the investment decision considerably. 
                                                 
1 1977, 1984, and 1987 are just some examples of years when the U.S. market was bearish, while foreign markets 
were bullish, providing a counter balance for diversified U.S. investors International financial investments are subject to currency risks and political risk [4], as well as a set of 
constraints such as taxation, foreign exchange controls, capital market regulations, transaction costs and 
required familiarity with foreign markets [3].  
While it might look attractive to the investor to purchase some foreign stocks for his portfolio, this might 
not be feasible after all additional cost and risk are considered. The performance improvement as a result 
of international portfolio investment must be measured only after allowing for these risks. Political 
uncertainty, lack of company information, lack of liquidity, trading and custodial difficulties, 
confidentiality and insider trading problems, higher transactions costs compared with developed countries 
are all part of the additional difficulties involved when investing internationally.  
International investment risks tend to be intensified in countries from the emerging markets in the Pacific 
Rim, Asia, Latin America, and former Eastern Bloc. Nevertheless, emerging markets, as a group, have 
much lower volatility than the individual markets because of low correlations between these markets. But 
even investing in emerging markets as a group no longer provides the degree of diversification that it 
previously did, as it becomes obvious that there has been a significant increase in the correlation between 
emerging markets and more developed markets, including the United States (see Table 2).  
 
Conclusion 
The most important step to be taken before making investment decisions is determining the degree of risk 
each particular investor is willing to take. Nevertheless, regardless of the amount of risk  aversion 
involved, international diversification can provide undeniable benefits in the context of increasing 
globalization. 
Even if investing in foreign securities is getting easier, there still exist significant barriers and 
complexities to this strategy such as transactions costs and lack of information. In the face of these 
obstacles it might be most sensible for the private investor to consider investing in international mutual 
funds - thus, a maximum of diversification can be exploited at low transactions cost and management 
fees. 
Although the risks involved with foreign investments cannot be completely eliminated, there are ways of 
reducing those risks, such as blending international stocks into a U.S. portfolio and investing for the long 
term. It is important to realize that foreign investments should be made with a long-term strategy in mind. 
The investment time horizon is a key element in taking this decision. International stocks can be volatile – 
especially in the short-term – therefore, rather than buying international stocks to provide a possible short-
term boost, they should be part of a long-term investment plan. 
Out of the wide range of international investment opportunities, emerging economies have historically 
been characterized by high average returns and large volatility [5]. Nevertheless considering the low 
correlation with developed country returns inclusion of these markets in a portfolio will significantly 
reduce portfolio volatility and increase expected returns.  
References: 
 
[1] David Goerz – “Benefits of International Investing”, September 2002 
http://www.mpowercafe.com/investing/analysis/analysis.3.3.3_09182002.html 
 
[2] Nahum Biger – “Exchange Risk Implications of International Portfolio Diversification”, Journal of 
International Business Studies, 1979, Volume 10, Issue 2 
 
[3] Sohnke Bartram and Gunter Dufey – “International Portfolio Investment: Theory, Evidence, and 
Institutional Framework”, Working Paper, University of Michigan, May 
2001, http://eres.bus.umich.edu/docs/workpap/wp01-006.pdf 
 
[4] Jean-Claude Cosset and Jean-Marc Suret – “Political Risk and the Benefits of International Portfolio 
Diversification”, Journal of International Business Studies, 1995, Volume 26, Issue 2  
[5] Campbell Harvey – “Predictable Risk and Returns in Emerging Markets”, The Review of Financial 
Studies, Fall 1995, Vol 8, No. 3 
 
[6] Joost Driessen and Luc Laeven – “International Portfolio Diversification Benefits: Cross-Country 
Evidence”, January 2002 
www1.fee.uva.nl/fm/PAPERS/Driessen/ Diversification_012002.pdf  
 
[7] Robert Durand, Lau Sim Yoon and Ross A. Maller – “Optimize to Beat the Benchmark: International 
Portfolio Diversification Revisited”, April 2002 
http://www.af.ecel.uwa.edu.au/__data/page/9373/02-152.pdf 
 
[8] Jim Wiandt – “Diversifying Internationally – Safe and Sensible”, July 2000 
http://www.indexfunds.com/PFarticles/20000725_international_com_intl_JW.htm 
 
[9] http://www.investorhome.com/intl.htm  
 
[10] Jeff Troutner –  “Are You Giving Up on Global Diversification?”, 
2001 http://www.indexfunds.com/PFarticles/1999_globaldiv_adv_sect_JT.htm  
 
[11] Alan C Shapiro – “Multinational Financial Management”, John Wiley & Sons, Inc., 1999 
 

and Luc Laeven – “International Portfolio Diversification Benefits: Cross-Country Evidence”,

Are You Giving Up on Global Diversification?”,

Dufey – “International Portfolio Investment: Theory, Evidence,

Exchange Risk Implications of International Portfolio Diversification”,

Jean-Marc Suret – “Political Risk and the Benefits of International Portfolio Diversification”,

Predictable Risk and Returns in Emerging Markets”, The Review of Financial Studies,

Shapiro – “Multinational Financial Management”,

International Portfolio Investment

http://www.rebe.rau.ro/RePEc/rau/jisomg/WI07/JISOM-WI07-A3.pdf

International Portfolio Investment

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