Risk Diversification In World Stock Markets

Abstract

The benefit of risk diversification refers to the reduction in the portfolio risk when different stocks are combined into a portfolio. This risk reduction benefit exists because not all stocks are moving together through time; this is presumably true for stocks from different countries. The smaller the degree of co-movements in the world stock markets (i.e., the less the correlation between the markets), the greater is the risk reduction effect. Thus, it makes sense for a US investor to invest globally as long as the foreign stock markets are not highly correlated with the U.S. market. Nevertheless, recent evidence shows that the correlations between the U.S. and various foreign stock markets are evolving through time due to the integration of world capital markets and international capital flows. Now that we witness the increased interdependence of the world stock markets, does it still make sense to diversify globally? In this paper, we address the question of global risk diversification from the US perspective.