Running head: Research Paper 1

Research Paper 1
FERNANDO LUZERNO AUGUSTO CARLOS LICHUCHA

Distance Learning Doctorate of Finance

Program

This paper is submitted in partial fulfillment of the

requirements for 5523S2001 DF Investments, Taxation
& Fraud Examination R2

School of Management
Program Name: Doctor of Finance
Course Professor: Dr. Ben Collins
b.collins@smcuniversity.com)

August 11, 2016

Research Paper 1

Is international investment diversification

prudent to either the individual or corporate
investor? Why?

Table of Contents
2

Research Paper 1
Abstract...................................................................................................................... 4
Introduction................................................................................................................ 6
The theory of investment diversification: A historical overview.................................9
Portfolio Theory....................................................................................................... 9
Capital Asset Pricing Theory..................................................................................10
Option Pricing Theory............................................................................................ 11
Alternative asset pricing models...........................................................................11
The Fama-French Model......................................................................................... 12
The Arbitrage Pricing Theory................................................................................. 12
Prudent Investor Rule............................................................................................... 12
Current Statement.................................................................................................... 13
Environmental Statement......................................................................................... 15
Discussion of Facts and Issues..................................................................................19
Analysis of Facts and Issues..................................................................................... 20
Conclusion................................................................................................................ 21
Recommendations.................................................................................................... 21
References................................................................................................................ 22

Research Paper 1

Abstract
This paper discusses the international investment diversification. It specifically finds out whether
it is prudent to either the individual or corporate investor. The discussion starts with a brief
characterization of international investment diversification as one of the four principal categories
of international investment or capital flows. Then, it gives a brief historical overview of the
theory of investment diversification including (Markowitz, 1952)s mean-variance investment
diversification theory and (Sharpe, 1964)s Capital Asset Pricing Model (CAPM). The concept
of Prudent Investor Rule is presented. Several experts discussions of current state of international
investment diversification are also presented and the summary is given by (Booth & Cleary,
2008) when they noted that although almost all experts agree that diversification in general , and
international investment diversification in particular, is one of the most critical components of
good portfolio management, evidence suggests the benefits of international diversification have
been declining as global markets have become more integrated.
Then, the paper moves on to discuss and analyse international investment diversification facts
and issues pointing out that with the financial globalisation, one would expect that investors
diversify internationally their portfolios and take advantage of international diversification.
However, investors present a strong preference for national assets because of asymmetric
information, inflation risk, non-traded assets, transaction costs and segmentation of financial
markets (Chkioua & Abaoub, 2012). The paper argues that despite these barriers to international
diversification the individual or corporate investor should find strategies to take the benefits from
international portfolio investment, namely the participation in growth of foreign markets,
hedging of consumption basket, international portfolio diversification, and market segmentation
(Bartram & Dufey, 2001).

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It concludes that although international diversification poses many problems, it is still prudent
for individual or corporate investor to build optimal international asset allocation including
stocks and bondsless correlated in different countries taking advantages of their industry
structure, resource endowments, macroeconomic policies, and non-synchronous business cycles
(Shapiro, 2003).

Research Paper 1

Introduction
International investment diversification or foreign portfolio investment is one of the four
principal categories of international investment or capital flows (i) commercial loans, (ii) official
flows, (iii) foreign direct investment (FDI), and (iv) foreign portfolio investment (FPI).
Foreign portfolio investment is a category of international investment that is more easily traded,
likely to be less permanent, and do not represent a controlling stake in an enterprise.
International investment diversification can be achieved via equity instruments (stocks) or debt
(bonds) of a foreign enterprise that does not necessarily represent a long-term interest (Suny
Levin Institute, n.d.).
Investment diversification is theoretically well-grounded in the finance literature with
(Markowitz, 1952)s mean-variance investment diversification theory and (Sharpe, 1964)s
Capital Asset Pricing Model (CAPM) suggesting that individual and institutional investors
should hold a well-diversified portfolio to reduce risk (Yavas, 2007).
(Levy & Sarnat, 1970) argues that these theoretical models of portfolio selection provide a
positive explanation and normative rules for the diversification of risky assets and
diversification can reduce risk depending upon the correlations among security returns. The
existence of a relatively high degree of positive correlation within an economy suggests the
possibility that risk reduction might be facilitated by diversifying securities portfolios
internationally.
(Yavas, 2007) points out that given the differences in the levels of economic growth and timing
of business cycles among various countries, international portfolio diversification can be used as
a means of reducing risk.

Research Paper 1
According to (Agati, 2007) in countries whose stock prices move in the same direction are
considered positively correlated while in countries whose stocks move in opposite directions are
negatively correlated. Thus, these opportunities can be taped according to the principle of
diversification that states that a portfolio containing mainly positively correlated assets holds the
portfolio at a higher risk than a portfolio with stock prices that are negatively correlated (Levy &
Sarnat, 1970).
(Bartram & Dufey, 2001) agree that it has been shown, that the crucial factor determining
portfolio risk for a given level of return is the correlation between the returns of the securities
that make up that portfolio. Ceteris paribus, low as opposed to high correlation between
securities means lower portfolio risk (portfolio diversification).
(Solnik, 1974), (Heston & Rouwenhorst, 1994) and (Griffin & Karolyi, 1998) as cited in (Brooks
& Negro, 2002) provide evidence on the advantages of cross-country diversification . (Bartram
& Dufey, 2001) add that there are several potential benefits that make it attractive for investors
to internationalize their portfolios, namely (a) the participation in the growth of other (foreign)
markets, (b) hedging of the investor's consumption basket, (c) diversification effects and,
possibly, (d) abnormal returns due to market segmentation. (Bartram & Dufey, 2001)

also

enumerates tangible benefits that an investor will benefit from having a greater proportion of
wealth invested in foreign securities (1) the higher their expected return, (2) the lower the
variation of their returns, (3) the lower the correlation of returns of foreign securities with the
investor's home market, and possibly, (4) the greater the share of imported goods and services in
her consumption.
(Bartram & Dufey, 2001) warns that even though these benefits might appear attractive, the
risks of and constraints for international investment diversification must not be overlooked

Research Paper 1
because in international context, financial investments are not only subject to currency risk and
political risk, but there are many institutional constraints and barriers including a host of tax
issues.
Thus, effective portfolio management strategies should be employed to mitigate risks and
constraints found in the international context.
This research paper seeks to find out if international investment diversification is prudent to
either the individual or corporate investor given the multiplicity of benefits, risks and constraints
in international context.

Research Paper 1

The theory of investment diversification: A historical

overview
Portfolio Theory
The field of portfolio investments has undergone a lot of changes since the publication of the
leading book on security analysis by (Graham & Dodd, 1951). By then, portfolio investments
consisted in picking winners by valuing stocks on the basis of an analysis of the firms assets,
earnings, dividends, and so on.
The picking winners approach gave little attention to how the winners were formed into
portfolios, or how such analysis could consistently succeed given the widespread competition
among investors for undervalued securities (Jensen & Smith, 1984).
In 1952 something big happen - mean-variance portfolio optimization analysis was developed by
Harry Max Markowitz, a Nobel Prize Laureate in Economics. (Markowitz, 1952) as cited in
(Smith, 1990) pointed that if risk is an undesirable attribute for investors, merely accumulating
predicted winners is a poor portfolio selection procedure because it ignores the effect of
portfolio diversification on risk. (Markowitz, 1952)s mean-variance portfolio optimization
analysis provides the mechanics of forming portfolios consisting of (1) formal content to the
meaning of diversification, (2) a measure of the contribution of the covariance among security
returns to the riskiness of a portfolio, and (3) rules for the construction of an efficient portfolio
(Smith, 1990).
According to (Jensen & Smith, 1984) portfolio theory implies that the firm should evaluate
projects in the same way that investors evaluate securities.

Research Paper 1

Capital Asset Pricing Theory

(Booth & Cleary, 2008) noted that (Markowitz, 1952)s mean-variance portfolio selection model
was extended by one of his students, William Sharpe, who thought through what it means for a
capital market dominated by Markowitz-type investors, rationally forming efficient portfolios.
(Sharpe, 1964) developed the Capital Marekt Line (CML) to determine the highest attainable
expected return for any given risk level that includes only efficent portfolios of interest of all
rational, risk-averse investors. (Sharpe, 1964) also developed risk-adjusted portfolio perfomance
racio, later on called Sharpe ratio, to assess the performance of efficent portfolios. In addition to
CML, that estimates the expected return of effiecient porfolios relative to their specific (nonsystematic) risk, (Sharpe, 1964) developed the Security Market Line (SML) that estimates the
required return on security or portfolio relative to its market (systematic) risk measured by beta.
Beta is commonly used meaure of market risk that relates the extent to which the return on a
security moves with that on the overall market (Booth & Cleary, 2008).
Both CML and SML are best known as Capital Asset Pricing Model (CAPM). The CAPM
points out that rational investors should not be compensated for specific or diversifible risk,
because it can be eliminated through (Markowitz, 1952)s mean-variance diversification model,
therefore, they should rewarded for taking market (systematic) risk.

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Research Paper 1

Option Pricing Theory

The capital asset pricing model estimates the required return on security or portfolio relative to
its market (systematic) risk assuming todays asset price as a function of expected future
cashflows. However, there are assets whose price depends on cashflows that are contingent on
the value of another asset. Black and Scholes (1973) provide a key to this problem in their
solution to the call option valuation problem (Jensen & Smith, 1984).

Alternative asset pricing models

The CAPM model uses only one risk factor, market risk, to estimate the expected return of a
security. The CAPM model is also criticized because it is based on unrealistic assumptions and a
substantial amount of empirical evidence finds that CAPM does not hold well in practice (Booth
& Cleary, 2008). The most prominent critique is by (Roll, 1977) as cited in (Booth & Cleary,
2008) that argued that the CAPM cannot be tested empirically because the market portfolio,
which consists of all risky assets cannot be observed. Therefore, researchers are forced to use
market proxies, which may or not be the optimal mean-variance efficient portfolio.
(Booth & Cleary, 2008) affirm that despite the criticisms, CAPM remains the most commonly
used method of estimating the required rate return because of its intuitive appeal for assessing
the tradeoff between risk and expected return.
In response to some of the problems associated with the CAPM, multi-factor models have been
developed a) the Fama-French model, and b) the Arbitrage Pricing Theory (APT).

The Fama-French Model

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Research Paper 1
It is a pricing model that uses three factors (a market factor, the market value of a firms common
equity, and the ratio of a firms book equity value to its market value of equity) to relate expected
returns to risk (Booth & Cleary, 2008).

The Arbitrage Pricing Theory

It is a pricing model that uses multiple factors to relate expected returns to risk by assuming that
asset returns are linearly related to a set of indexes, with proxy risk factors that influence security
returns (Booth & Cleary, 2008).

Prudent Investor Rule

The Prudent Investor Rule is a legal doctrine which provides guidance to investment managers
regarding the standards for managing an investment portfolio in a legally satisfactory manner
(Prudent Investor Rule, 1992). The Prudent Investor Rule states that, inter-alia, (i) Sound
diversification is fundamental to risk management, and (ii) Investment risk should be
deliberately taken on only when it is judged likely to contribute to desirable investment
performance for the portfolio as a whole (Prudent Investor Rule, 1992).

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Current Statement
The portfolio theory showed that the inclusion of slightly correlated assets in a portfolio reduces
significantly the risk (Markowitz, 1952). At the international level, the benefits of international
diversification were highlighted since pioneer works of Grubel (1968), Levy and Sarnat (1970),
and Solnik (1974) as cited in (Chkioua & Abaoub, 2012). These benefits are allotted to weak
correlation between financial markets.
(Eiteman, Stonehill, & Moffett, 2012) argue that the benefits of international diversification are
now obvious in that the optimal international portfolio is superior to the optimal domestic
portfolio (Figure 1). The investors optimal international portfolio, IP, possesses both higher
expected portfolio return (RIP > RDP), and lower expected portfolio risk (IP < DP), than the
purely domestic optimal portfolio.

Figure 1 The Gains from International Portfolio Diversification

Source: (Eiteman, Stonehill, & Moffett, 2012, p. 8)

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(Booth & Cleary, 2008) agree with the (Eiteman, Stonehill, & Moffett, 2012)s (Figure 1) when
he argues that the expectation is that the returns among stock returns in different global markets
have lower correlation coefficients than those in the same market. (Booth & Cleary, 2008) cited
the benefits of international diversification in reducing portfolio risk based on evidence provided
in a classic research article by (Solnik, 1995) depicted in (Figure 2). In this figure international
diversification yields high risk reduction then domestic diversification in USA market.

Figure 2 International diversification

Source: (Booth & Cleary, 2008, p. 327)

Environmental Statement

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Research Paper 1
(Abid, Leung, Mroua, & Wong, 2014) state that despite greater integration of international
capital markets, investors continue to hold portfolios largely dominated by domestic assets and
international investors preference for domestic stocks remains a subject of controversy, since
many studies indicate that greater profits can be made by diversifying internationally. For
example, (Solnik, 1995) as cited in (Abid, Leung, Mroua, & Wong, 2014) shows that substantial
advantages in risk reduction can be attained through portfolio diversification in foreign securities
as well as in domestic common stocks. (Cheol S. Eun, 1994) as cited in (Abid, Leung, Mroua, &
Wong, 2014) find potential gains from international diversification. (Li, Sarkar, & Wang, 2003)
as cited (Abid, Leung, Mroua, & Wong, 2014) reveal that the benefits of international
diversification are substantial for US equity investors even though short selling is not allowed.
(Meyer & Rose, 2003) as cited in (Abid, Leung, Mroua, & Wong, 2014) find that international
diversification can be advantageous and forms a means for managing crises in developed
markets. (Carrieri & Sarkissian, 2004) as cited in (Abid, Leung, Mroua, & Wong, 2014) show
that greater diversification gains can potentially be achieved if local industry investment is
country specific and that investors should use both cross-country and cross-industry
diversification as a way to improve portfolio performance.
(Driessen & Laeven, 2005) as cited in (Abid, Leung, Mroua, & Wong, 2014) document that the
potential benefits from investing abroad remain substantial and the gains from international
portfolio diversification are larger for countries with higher country risk. (Chiou, 2009) as cited
in (Abid, Leung, Mroua, & Wong, 2014) finds that adding lower and upper weighting bounds
reduces, but does not completely eliminate, the potential economic value of international
investment. (Eun, Lai, Roon, & Zhang, 2009) as cited in (Abid, Leung, Mroua, & Wong, 2014)

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show that factor fund diversification strategies yield substantial improvements in portfolio
efficiency beyond what can be achieved by traditional country market index diversification.

Despite the evidence of the potential gains from international diversification, (French & Poterba,
1991) as cited in (Abid, Leung, Mroua, & Wong, 2014) show that most investors hold nearly all
of their wealth in domestic assets. (Tesar & Werner, 1992) as cited in (Abid, Leung, Mroua, &
Wong, 2014) report that domestic diversification was very evident in 1996. (Lewis, 1999) as
cited in (Abid, Leung, Mroua, & Wong, 2014) shows that domestic stocks are a better hedge
against home risks than foreign stocks.
(Kilka & Weber, 2000) as cited in (Abid, Leung, Mroua, & Wong, 2014) show that actual equity
portfolio holdings reveal a strong bias toward domestic stocks and conclude that this bias can be
explained by the stock return expectations expressed in probability judgments. (Oehler, Rummer,
& Wendt, 2008) as cited in (Abid, Leung, Mroua, & Wong, 2014) reveal that one of the
phenomena documented in investment portfolios is the home-bias effect, since investors hold a
higher-than-optimal portion of domestic assets. (Antoniou, Olusi, & Paudyal, 2010) as cited in
(Abid, Leung, Mroua, & Wong, 2014) examine whether British investors need to diversify their
portfolios internationally to gain performance benefits from international markets or whether
they can obtain these benefits by mimicking the portfolios with domestically traded assets.
(French & Poterba, 1991) states that although benefits of international diversification have been
recognized for decades, most investors hold nearly all of their wealth in domestic assets.
In their paper, (French & Poterba, 1991) tried to find an explanation of why portfolio investors
in the United Kingdom and Japan overweight their own equity market using Institutional and
Behavioral Explanations for

international under diversification.

Regarding institutional

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explanations, (French & Poterba, 1991) found no prove for international under diversification
because

there is little difference between foreign and domestic tax burdens for most investors

to lead investors toward holding domestic equity,

transaction costs also appear unable to explain limited international diversification
because the cost of trading may be lower in more liquid markets such as New York than
elsewhere, but this should incline all investors toward the most liquid market, not toward

their own domestic market (French & Poterba, 1991), and

explicit limits on cross-border investment could also affect portfolio holdings, but in
reality are not enforced. (French & Poterba, 1991) points out that in France, for
example, a foreign investor may not hold more than 20 percent of any firm without
authorization from the Ministry of Economy and Finance and in Japan, insurance
companies cannot hold more than 30 percent of their assets in foreign securities

Regarding the investor behavior three factor for limited international diversification are
identified by (French & Poterba, 1991)

return expectations vary systematically across groups of investors (French & Poterba,
1991). (Shiller, Kon-ya, & Tsutsui, 1991) as cited in (French & Poterba, 1991) surveyed
portfolio managers in Japan and the United States. The U.S. investors expected an
average return of -0.3 percent on the Dow Jones Industrial Average over the next twelve
months, compared with an expected return of -9.1 percent on the Nikkei. In contrast,
Japanese investors expected an average return of 12.6 percent on the Dow, and 10.8
percent on the Nikkei. While the Japanese investors were more optimistic than their U.S.

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counterparts with respect to both markets, they were relatively more optimistic about the

Tokyo market (French & Poterba, 1991),

statistical uncertainties associated with estimating expected returns in equity markets
using historic data that produce indicative information harder to be used by international

portfolio investors, so they prefer to use their own wisdom (French & Poterba, 1991), and
perception of risk in equity markets because international portfolio investors tend to
add extra "risk" to foreign investments because they know less about foreign markets,
institutions, and firms (French & Poterba, 1991).

Thus, the lack of diversification appears to be the result of investor choices, rather than
institutional constraints (French & Poterba, 1991).
Finally, (Booth & Cleary, 2008) note that although almost all experts agree that diversification in
general, and international investment diversification in particular, is one of the most critical
components of good portfolio management, evidence suggests the benefits of international
diversification have been declining as global markets have become more integrated.

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Research Paper 1

Discussion of Facts and Issues

In terms of (Markowitz, 1952)s mean-variance investment diversification theory and (Sharpe,
1964)s Capital Asset Pricing Model (CAPM) internationally diversified portfolios are the same
in principle for individual or corporate investor because both investors construct internationally
diversified portfolios in an attempt to combine assets which are less than perfectly correlated,
reducing the total risk of the portfolio. In addition to that, by adding assets outside the home
market, the investor tries to tap into a larger pool of potential investments.
The major problems with international diversification for individual or corporate investor are
(i) foreign exchange risk in internationally diversified portfolios (Eiteman, Stonehill, & Moffett,
2012),

(ii) asymmetric information, inflation risk, non-traded assets, transaction costs and

segmentation of financial markets (Chkioua & Abaoub, 2012), (iii) differences in accounting and
taxation policies that can raise or lower returns, lack of liquidity due to the small size of
securities markets and the low trading volume (J.P. Morgan, 2014). Although international
diversification poses many problems, it is still prudent for individual or corporate investor to tap
to it by building optimal international asset allocation including stocks and bonds. The individual
or corporate investor can build a diversified combination of stocks and bonds less correlated in
different countries taking advantages of their industry structure, resource endowments,
macroeconomic policies, and non-synchronous business cycles (Shapiro, 2003).

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Analysis of Facts and Issues

With the financial globalisation, one would expect that investors diversify internationally their
portfolios and take advantage of less correlated industry structure, resource endowments,
macroeconomic policies, and non-synchronous business cycles (Shapiro, 2003). However,
investors present a strong preference for national assets because of asymmetric information,
inflation risk, non-traded assets, transaction costs and segmentation of financial markets
(Chkioua & Abaoub, 2012).
Despite these barriers to international diversification the individual or corporate investor should
find strategies to take the benefits from international portfolio investment, namely the
participation in growth of foreign markets, hedging of consumption basket, international
portfolio diversification, and market segmentation (Bartram & Dufey, 2001).
Emerging markets have delivered higher average returnswith commensurately higher volatility
than those of developed markets. From 1985 through 2013, emerging markets produced an
average annual return of 12.7% with an average volatility of 24.0%, versus average annual
returns for developed markets over the same period of 9.9% with an average volatility of 17.6%
(Philips, 2014).
Although, all investments are subject to risk, including possible loss of principal and
diversification does not ensure a profit or protect against a loss in a declining market the
potential benefits to be taped are huge and the individual or corporate investor should consider
strategies with a reasonable trade-off between the opportunity for diversification and the realities
of the global equity and

bond markets (Philips, 2014) to ensure prudential international

investment diversification according to Prudent Investor Rule.

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Conclusion

Although international diversification poses many problems, it is still prudent for individual or
corporate investor to build optimal international asset allocation including stocks and bonds less
correlated in different countries taking advantages of their industry structure, resource
endowments, macroeconomic policies, and non-synchronous business cycles (Shapiro, 2003).

Recommendations

Individual or corporate investor should overcome the home-bias effect in portfolio building since
many studies indicate that greater profits can be made by diversifying internationally. However,
since all investments are subject to risk, including possible loss of principal, the individual or
corporate investor should consider strategies with a reasonable trade-off between the opportunity
for diversification and the realities of the global equity and bond markets (Philips, 2014) to
ensure prudential international investment diversification according to Prudent Investor Rule.

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