Global Equity Markets and International Diversification

Abstract

Interest in global investing has increased tremendously over the last several years. U.S. investors seek to reduce risk by diversifying globally. The risk reduction benefits hinge upon the relationships between U.S. stock market indexes and other international stock market indexes. Portfolio research studies have shown that adding new assets that have low correlation with those already held will enhance the risk to return ratio for the new portfolio. Global diversification may provide a similar risk reduction when an investor’s portfolio is expanded to include foreign securities. This study examines relationships between U.S. stock markets and world equity markets to investigate whether international diversification provides additional diversification benefits to U.S. investors.

The data for this study include the annualized equity returns and standard deviations computed for 61 indexes (11 Morgan Stanley Capital International (MSCI) Indexes and 50 national market indexes that were calculated for the period January 1988 to November 2001. Nine portfolio diversification strategies are examined to obtain efficient frontiers. These portfolios are constructed based upon risk-reward ratios (coefficients of variation), systematic risk (beta) and using different MSCI International Market Indexes.

Our analysis suggests that: (1) a portfolio constructed based on coefficients of variation of less than 2 (no index had a ratio of less than 1) as a criterion had the best result; (2) the domestic portfolio (S&P₅₀₀) provided the second best risk-return to the investors; (3) among MSCI Indexes, FAREAST indexes had the worst performance as did China among the 50 countries; (4) the presumption that low correlations (less than 0.5) would be an attractive means of reducing the portfolio risk did not produce the best risk-return trade off; and (5) the size of the coefficients and long-term stability of the correlations between country indexes have increased.

Finally, the efficient frontier’s point of inflection for this study (January 1988-November 2001) for most of the portfolios occurred at more than 45 percent investment in U.S. market. This result is consistent with prior studies that found the point of inflection for a portfolio consisting of U.S. and foreign stock markets generally occurs at about 40 percent. Our result is dramatically different from the Sharma, Obar, and Moser (1996) study that concluded the point of inflection for their four portfolios occurred with only 10 percent invested in the U.S. market.