Business and Management Research Journal Vol. 6(10): 100 - 108, October 2016
Available online at http://resjournals.com/journals/research-in-business-and-management.html
ISSN: 2026-6804 ©2016 International Research Journals
Full Length Research Paper
International Portfolio Theory and Diversification: An
Overview
*Sa’adu Abdul Hakeem1, Hussaini Sulaiman Tsoho2 and Ibrahim Abdul Malik Dogara3
1
Department of Business Administration and Entrepreneurship, Bayero University, Kano, Nigeria
2
Department of Banking and Finance, Nuhu Bamalli Polytechnic, Zaria, Kaduna State, Nigeria
Email:[email protected]
3
Department of Accounting, Ahmadu Bello University, Zaria, Kaduna State, Nigeria Email: [email protected]
*Corresponding Author’s Email: [email protected]
Abstract
The objective of this study is to examine the influence of international portfolio diversification on the stock
markets of a country. The methodology of the study was basically on existing literatures of international
portfolio theory as a secondary source of data. It was concluded that amongst the benefit of international
diversification is for investors to invest in the securities that will result in low risk reduction for a given high
return. It was recommended among others that returns on cross boarder market do not move exactly in the
same way all the times, will result in diversification gains.
Key words: International portfolio, portfolio theory and international diversification
Introduction
During this era of globalization, portfolio investors are
interested in international as well as regional investment
portfolios rather than a local investment portfolio. Sharpe
(1964) has explained in his seminal paper that
diversification can remove the unsystematic risk through
making investment portfolios. However, international
portfolios are capable of reducing the systematic risk
(Hui 2005). Therefore, the investigation into the
movement of international equity markets is one of
the sources of information for investment portfolios
and hedging decisions.
Portfolio diversification through Mean-variance
approach is introduced by the Markowitz (1952) in his
seminal paper "Portfolio Selection" and this
framework was supported by many researchers
thereafter (Eun and Shim 1989; Lessard 1973; Solnik
1974). Therefore, international investors are
interested in the stocks of those countries which are
inversely related to one another. Normally, their
course of interact is found to be in opposite direction.
Some early researchers examined the evidence of
converse movement among many financial markets
(Ripley 1973; Panton et al. 1976; Hilliard 1979).
International capital movement was increased by
mega globalization and financial liberalization since
late 1980s, which enhanced the competitiveness of
firms internationally. That's become the cause of
industrialization in the emerging economies. This
tendency attracted international investors for broader
chance of diversification for their investment
portfolios. Hui and Kwan (1994) investigated the
impact of diversification in the context of Asian Pacific
markets. Furthermore, the study of Shachmurove
(1998) explained diversification opportunities in the
South American markets. Hui (2005) used data from
mature and emerging markets through factor analysis
approach to investigate to exploit investment
opportunities in these markets in international
perspective.
The movements among equity markets were
increased substantially during and after the
international financial crisis 1987(Arshanapalli and
Doukas 1993; Meric and Meric 1997). Some recent
studies proved that movement of stock prices was
increased during and post Asian Financial crisis 1997
100
(Yang et al. 2003; Aggarwal et al. 2003; Sharma and
Bodla 2010) and US subprime crisis 2007(Yu et al.
2010; Saha and Bhunia 2011; Li et al. 2012). The
direction of causality was not found same in both
during the Asian crisis and subprime crisis. Volatility
transmission was directed by Asian equity markets
towards the US equity markets during Asian Crisis,
while this case was reversed during the subprime crisis
(Yoshida2011)
For the guidance of global international portfolio
investors, a recent analysis is required to investigate co
integration in context of Asian markets post the
subprime crisis of 2007. Hwang (2012) mentioned in his
recent research that a study should be conducted to
examine the changes in global stock markets before,
during, and after the global financial crisis. This study
intends to fill this research gap by exploring the effect of
international portfolio theory on global equity market as
well as the benefit of international diversification of
portfolio in the international financial market.
The main objectives of this study are:
i.
To discuss the theoretical foundation and
empirical finding of international portfolio theory
literatures.
ii.
To examine the influence of international
portfolio theory on investment of a country’s
stock market.
The methodology of the study is strictly on reviewing
information which is basically obtained from various
existing theoretical and empirical literatures on
international portfolio theory and diversification.
Conceptualization of variables
International Portfolio
This is the grouping of investment assets that focuses
on securities from foreign markets rather than domestic
markets. An international portfolio is designed to give
the investor exposure to growth in emerging and
international markets and provide diversification.
International portfolios allow investors to further diversify
their assets by moving away from a domestic-only
portfolio. This type of portfolio can carry increased risk
due to potential economic instability stemming from
emerging markets, but can also bring increased stability
through investments in industrialized and more stable
markets (Frahm & Wiechers, 2013).
However, this paper views international portfolio as
those stocks that investors try to invest in them across
international stock markets of different countries of the
world.
International portfolio diversification
This is the allocation of investments in a portfolio of
international securities in order to achieve broader
equity exposure to many foreign markets while
spreading the risk associated with investing in any one
foreign market. Under this concept, diversification can
be defined as the uniformity of risk contributions across
a portfolio's components (Maillard, Roncalli, Teiletche,
2009). It is worth to note that the international portfolio
theory was derived from the study of modern portfolio
theory of Harry Markowitz (1952).
Principles of international portfolio investment
Individuals must allocate their income among current
consumption, productive investment, and financial
investment. Simplifying these choices by assuming that
consumption and productive investment decisions have
already been made and thereby omitting potential
feedback effects leaves the portfolio decision narrowly
defined: how to allocate the remaining wealth to financial
and/or real assets so as to maximize the most desirable
return, i.e. consumption in the future. Despite this
simplification, there is still a bewildering array of forms in
which wealth can be held, ranging from non-liquid
holdings of real estate, through gold coins and
commodity futures, all the way to stocks, bonds, savings
accounts, money market securities, and cash
equivalents. Investment theory, then, comprises the
principles that help investors to rationally allocate their
wealth between the different investment alternatives
(Solnik, 2000).
In the context of IPI, which involves investment not
only in domestic, but also in foreign securities, the
established investment concepts of portfolio theory and
capital market theory must be modified and extended to
take into account the international dimension. Whereas
the basic principles also mostly apply on an international
scale, additional considerations become necessary. An
important issue that arises if portfolios are composed of
securities from different countries is the choice of a
numeraire for measuring risk and expected return. As a
matter of tradition and/or due to regulation, local
currency is used in most cases to calculate these
security characteristics, which means that return and
variance values for foreign securities need to be
adjusted for currency gains or losses (Shapiro, 1993). It
has to be noted, however, that foreign goods and
services represent a significant proportion of the
consumption basket in many countries. Therefore, if
purchasing power were to be maintained, the
maximization of local currency returns may not be
optimal in this regard (Odier & Solnik, 1993).
The Capital Asset Pricing Model (CAPM) has been
developed with respect to major capital markets in the
world. It is well accepted and widely used by
professional portfolio managers to analyze the pricing of
securities in national financial markets. However, since
the scope of securities under consideration is enlarged
to incorporate equities of all markets around the globe,
and since the cost of obtaining information and
restrictions are generally eliminated, it may be argued
that capital markets have become increasingly
"integrated", and securities' prices might actually be
determined by internationally integrated, as opposed to
segmented, financial markets.5 With integrated capital
markets, optimal diversification is realized by forming a
global market portfolio, and the riskiness of all securities
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in the world is measured according to their contribution
to the risk of this portfolio ( Levi, 1996).
Literature review
The foundation for Modem Portfolio Theory ("MPT") was
established in 1952 by Harry Markowitz with the writing
of his doctoral dissertation in statistics. The most
important aspect of Markowitz' model was his
description of the impact on portfolio diversification by
the number of securities within a portfolio and their
covariance relationships (Megginson, 1996). His
dissertation findings, entitled "Portfolio Selection"
(1952), were first published in The Journal of Finance.
Subsequently, these findings were significantly
expanded with the publication of his book, Portfolio
Selection: Efficient Diversification (1959). However, this
set the pace for other researchers to develop further on
the theory of portfolio diversification in the different
economies of the world.
In 1958, economist James Tobin in his essay,
"Liquidity Preference as Behavior Toward Risk," in
Review of Economic Studies, derived the 'Efficient
Frontier' and 'Capital Market Line' concepts based on
Markowitz' works. Tobin's model suggested that market
investors, no matter their levels of risk tolerance, will
maintain stock portfolios in the same proportions as long
as they "maintain identical expectations regarding the
future" (Megginson, 1996, citing Tobin, 1958).
Consequently, concluded Tobin, their investment
portfolios will differ only in their relative proportions of
stocks and bonds. Independently developed by William
Sharpe, John Lintner, and J an Mossin, another
important capital markets theory evolved as an
outgrowth of Markowitz' and Tobin's earlier works-The
Capital Asset Pricing Model (CAPM) (Megginson, 1996).
The CAPM provided an important evolutionary step in
the theory of capital markets equilibrium, better enabling
investors to value securities as a function of systematic
risk. Sharpe (1964) significantly advanced the Efficient
Frontier and Capital Market Line concepts in his
derivation of the CAPM. Sharpe would later win a Nobel
Prize in Economics for his seminal contributions. A year
later, Lintner (1965) derived the CAPM from the
perspective of a corporation issuing shares of stock.
Finally, in 1966, Mossin also independently derived the
CAPM, explicitly specifying quadratic utility functions
(Megginson, 1996). Since the earlier works of
Markowitz, and later, Sharpe, Lintner and Mossin, there
have been various expansions and iterations of MPT.
The remainder of this essay addresses a perceived
"simplicity" gap in that literature, and suggests a
systemic failure of theorists and practitioners to
capitalize upon the tremendous advances in finance and
technology.
The international portfolio diversification theory is an
improvement upon traditional investment models and is
an important advancement in the mathematical
modelling of finance. The theory encourages asset
diversification to hedge against market risk as well as
risk that is unique to a specific company. The theory
hinges upon the modern portfolio theory which is a
sophisticated investment decision approach that assists
an investor to classify, estimate, and control both the
kind and the amount of expected risk and return from a
given set of portfolio. Essential to the portfolio theory are
its quantification of the relationship between risk and
return and the assumption that investors must be
compensated for assuming risk. Portfolio theory departs
from traditional security analysis in shifting emphasis
from analysing the characteristics of individual
investments to determining the statistical relationships
among the individual securities that comprise the overall
portfolio (Edwin & Martins, 1997). The IPT
mathematically formulates the concept of diversification
in investing, with the aim of selecting a collection of
investment assets that has collectively lower risk than
any individual asset. This can be inferred intuitively
because different types of assets often change in value
in opposite ways and that diversification lowers risk even
if assets returns are not negatively correlated and even
if they are positively correlated (Omisore, Yusuf, &
Christopher, 2012).
Diversifying investment portfolio can protect an
investor from either an international or localized dips in
the market, but it can also prevent the investor from
making big money. The question of what breadth of
diversification is appropriate is an ongoing conversation
among financial professionals. Finding the right
diversification level for yourself involves an analysis of
your assets and your tolerance of risk (Bekiros, 2014).
Modem portfolio theory
Technically speaking Modem Portfolio Theory (MPT) is
comprised of Markowitz Portfolio Selection theory, first
introduced in 1952, and William Sharpe's contributions
to the theory of financial asset price formation which was
introduced in 1964, which came be known as the Capital
Asset Pricing Model (CAPM) (Veneeya, 2006).
Essentially, MPT is an investment framework for the
selection and construction of investment portfolios
based on the maximization of expected returns of the
portfolio and the simultaneous minimization of
investment risk (Fabozzi, Gupta, & Markowitz, 2002).
Overall, the risk component of MPT can be
measured, using various mathematical formulations, and
reduced via the concept of diversification which aims to
properly select a weighted collection of investment
assets that together exhibit lower risk factors than
investment in any individual asset or singular asset
class. Diversification is, in fact, the core concept of MPT
and directly relies on the conventional wisdom of "never
putting all your eggs in one basket" (Fabozzi, Gupta, &
Markowitz, 2002; McClure, 2010; Veneeya, 2006).
It is instructive to note here that Markowitz' portfolio
selection theory is a normative theory. Fabozzi, Gupta,
& Markowitz (2002) define a normative theory as one
that describes a standard or norm of behavior that
investors should pursue in constructing a portfolio.
Conversely, Sharpe's asset pricing theory (CAPM) is
regarded as a positive theory one that hypothesizes how
investors actually behave as opposed to how they
should behave. Together, they provide a theoretical
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framework for the identification and measurement of
investment risk and the development of relationships
between expected return and risk. There remains a
degree of debate as to whether or not MPT is
interdependent upon the validity of asset pricing theory
(Fabozzi, Gupta, & Markowitz, 2002). This analysis
assumes that MPT is indeed independent of asset
pricing theory, with the latter concept the subject of
separate analysis.
The framework for IPT(international portfolio theory)
includes numerous assumptions about markets and
investors. Some of these assumptions are explicit, while
others are implicit. Markowitz built his portfolio selection
contributions to MPT on the following key assumptions
(Bofah, Wecker & Markowitz, 1952): i.) Investors are
rational (they seek to maximize returns while minimizing
risk), ii.) Investors are only willing to accept higher
amounts of risk if they are compensated by higher
expected returns, iii.) Investors timely receive all
pertinent information related to their investment
decision, iv.) Investors can borrow or lend an unlimited
amount of capital at a risk free rate of interest, v.)
Markets are perfectly efficient, vi.) Markets do not
include transaction costs or taxes, vii.) It is possible to
select securities whose individual performance is
independent of other portfolio investments. These
foundational assumptions of international portfolio theory
have been widely challenged.
Risk and return
Financial risk can be defined as deviation away from
expected historical returns during a particular time
period (Bofah & McClure, 2010). However, Markowitz'
portfolio selection theory maintains that the essential
aspect pertaining to the risk of an asset is not the risk of
each asset in isolation, but the contribution of each
asset to the risk of the aggregate portfolio (Royal Sedish
Academy of Sciences, 1990).Risk of a security can be
analyzed in two ways: (i) stand-alone basis (asset is
considered in isolation), and (ii) portfolio basis (asset
represents one of many assets). In context of a portfolio,
the total risk of a security can be divided into two basic
components: systematic risk (also known as market risk
or common risk), and unsystematic risk (also known as
diversifiable risk). MPT assumes that these two types of
risk are common to all portfolios.
Systematic, risk is a macro level form of risk that
affects a large number of assets to one degree or
another (Ross, Westerfield, & Jaffe, 2002). General
economic conditions, such as inflation, interest rates,
unemployment levels, exchange rates or gross national
product levels are all examples of systematic risk
factors. These types of economic conditions have an
impact on virtually all securities to some degree.
Accordingly, systemic risk cannot be eliminated.
Unsystematic risk, on the other hand, is a micro level
form of risk factors that specifically affect a single asset
or narrow group of assets (Ross, Westerfield, & Jaffe,
2002). It involves special risk that is unconnected to
other risks and only impacts certain securities or assets.
Other examples of unsystematic risk might include a
firm's credit rating, negative press reports about a
business, or a strike affecting a particular company
(Helela, n.d.).
Unsystematic risk can be significantly reduced by the
diversification of securities within a portfolio (McClure,
2010). Since, in practice, the returns on different assets
are correlated to at least some degree, unsystematic
risk can never truly be completely eliminated regardless
of how many types of assets are aggregated in a
portfolio (McClure, 2010; Royal Swedish Academy of
Sciences, 1990).
Risk and return trade off
The concept of risk and return trade-off relates to
Markowitz' basic principle that the riskier the investment,
the greater the required potential return. Generally
speaking, investors will keep a risky security only if the
expected return is sufficiently high enough to
compensate them for assuming the risk (Ross,
Westerfield, & Jaffe, 2002). The risk represents the
chance that the actual return of an investment will be
different than expected, which is technically measured
by
standard
deviation
(RiskReturn
Tradeoff/Investopedia, 2016). A higher standard
deviation translates into a greater risk and requisite
higher potential return. If investors are willing to bear
risk, then they expect to earn a risk premium. Risk
premium is the return in excess of the risk-free rate of
return that an investment is expected to yield (Risk
PremiumlInvestopedia, 2016). The greater the risk, the
more investors require in terms of a risk premium. Some
risks can be easily and cheaply avoided and, as such,
bear no expected reward. It is only those risks that
cannot be easily avoided that are compensated on
average (Bradford, & Miller, 2009). The risk return trade
off points only to the possibility of higher return of
investments-not guarantees of a higher return. As such,
riskier investments do not always pay more than a riskfree investment. This is what exactly makes them risky.
However, historical analysis demonstrates that the only
way for investors to earn higher returns is to make
riskier investments (Bradford, & Miller, 2009).
Expected return
In order to predict future returns (expected return) for a
security or portfolio, the historical performance of returns
are often examined. Expected return can be defined as
the average of a probability distribution of possible
returns (Bradford, & Miller, 2009). Calculation of the
expected return is the first step in Markowitz' portfolio
selection model. Expected return, also commonly
referred to as the mean or average return, can simply be
viewed as the historic average of a stock's return over a
given period of time (Benniga, 2006). Calculations for a
portfolio of securities (two or more) simply involve
calculating the weighted average of the expected
individual returns (Ross, Westerfield & Jaffe, 2002).
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Portfolio return variance
There are various ways to determine the volatility (risk)
of a particular security's return. The two most common
measures are variance and standard deviation. Variance
is a measure of the squared deviations of a stock's
return from its expected return the average squared
difference between the actual returns and the average
return (Bradford, & Miller, 2009; Ross, Westerfield &
Jaffe, 2002). When many assets are held together in a
portfolio, assets decreasing in value are often offset by
portfolio assets increasing in value, thereby minimizing
risk. Therefore, the total variance of a portfolio of assets
is always lower than a simple weighted average of the
individual asset variances (Frantz & Payne, 2009).
Analyst’s observations indicate that the variance of a
portfolio decreases as the number of portfolio assets
increases (Frantz & Payne, 2009). According to Frantz
and Payne (2009), increasing the number of portfolio
assets significantly improves its Efficient Frontier (the
efficient allocations of diversified assets for variable
risks). To a degree, the returns on these types of assets
tend to cancel each other out, suggesting that the
portfolio variance return of these assets will be smaller
than the corresponding weighted average of the
individual asset variances (Frantz & Payne, 2009).
Accordingly, maintaining portfolios comprised of a
greater number of assets allows investors to more
effectively reduce their risk.
In actuality, once the number of assets in a portfolio
becomes large enough, the total variance is actually
derived more from the covariance than from the
variances of the assets (Schneeweis, Crowder, &
Kazemi, 2010). The significance of this is that it
reinforces the concept that it is more important how
assets tend to move within a portfolio rather than how
much each individual asset fluctuates in value.
Standard deviation
This is another common measure of volatility is the
standard deviation of a security. Markowitz' portfolio
selection model makes the general assumption that
investors make their investment decisions based on
returns and the risk spread. For most investors, the risk
undertaken when purchasing a security either
internationally or regionally they will receive returns that
are lower than what was expected. As a result, it is a
deviation from the expected (average) return. Put
another way, each security presents its own standard
deviation from the average (McClure, 2010). A higher
standard deviation translates into a greater risk and a
required higher potential return. The standard deviation
of a return is the square root of the variance (Bradford,
& Miller, 2009). The standard deviation of expected
returns requires the statistical calculation of several
factors which will help to measure the return's volatility.
International diversification
The terms international diversification and diversification
effect refer to the relationship between correlations and
portfolio risk. International diversification, is a
cornerstone of Markowitz' portfolio selection theory and
MPT, is a risk reduction concept that involves the
allocation of investments among various financial
instruments internationally, industries and other
investment categories (Importance of diversification,
2009). In more simplistic terms, it relates to the wellknown adage don't put all your eggs in one basket. If
the basket is dropped, all eggs are broken; if placed in
more than one basket, the risk that all eggs will be
broken is dramatically reduced (Fabozzi, Gupta, &
Markowitz, 2002). International diversification can be
achieved by investing in different stocks, different asset
classes (e.g. bonds, real estate, etc.) and/or
commodities such as gold or oil in different countries of
the world. Diversification Effect refers to the relationship
between correlations and portfolios (Gibson, 1990).
When the correlation between assets is imperfect
(positive, negative), the result is the diversification effect.
It is an important and effective risk reduction strategy
since risk reduction can be achieved without
compromising returns (Right, 2010).
Efficient frontier
Efficient frontier also referred to as Markowitz efficient
frontier, is a key concept of MPT. It represents the best
combination of securities those producing the maximum
expected return for a given risk level within an
investment portfolio. It describes the relationship
between expected portfolio returns and the riskiness or
volatility of the portfolio. It is usually depicted in graphic
form as a curve on a graph comparing risk against the
expected return of a portfolio. The optimal portfolios
plotted along this curve represent the highest expected
return on investment possible, for the given amount of
risk (McClure, 2010). Portfolios lying on the efficient
frontier represent the best possible combination of
expected return and investment risk. The relationship
between securities within a portfolio is an important part
of the efficient frontier. For instance, the price of some
securities in a portfolio moves in the same direction,
while the price in others moves in opposite directions.
The greater the covariance (the more they move in
opposite), the smaller the standard deviation (the
smaller the risk) within the portfolio. One of the major
implications of Markowitz' efficient frontier theory is its
inferences of the benefits of diversification (Efficient
frontier/Investing Answers, 2016.). Diversification, as
discussed above, can increase expected portfolio
returns without increasing risk. Markowitz' theory implies
that rational investors seek out portfolios that generate
the largest possible returns with the least amount of risk
portfolios on the efficient frontier.
Review of empirical Literature
The empirical literature regarding benefits of
international diversification is available since 1960s. As
Grubel (1968) used mean-variance methodology by
reducing country systematic risk in international
diversification. This risk-adjusted diversification was
104
studied by many researchers such as (Wilcox 1992;
Bekaert & Harvey 1995; Divecha et al. 1992; Speidell &
Sappenfield 1992; Harvey 1995). Some notable studies
applied VAR methodology by using cointegration and
causality tests to reveal the function of emerging equity
markets for the diversification of risk (Gilmore and
McManus 2002; Gilmore et al. 2005; Naranjo and Porter
2007; Olgun & Ozdemir 2008; Ozdemir 2009; Ozdemir &
Cakan 2007; Ozdemir et al. 2009).
Various methodologies were used by the researchers
for the determination of co-movement among the stock
indices. Traditionally, degree and direction of
correlations was applied to diversify the risk of portfolio.
As increase in the number of markets, this bivariate
technique was gradually replaced by multivariate
techniques. Ripley (1973) used data of 19 international
stock markets covering the period from 1960 to 1970 to
investigate the pattern of variation among these markets
through applying factor analysis technique. Results
showed that Switzerland, Netherlands, Canada, and US
were found in low degree of variability, whereas Japan
and South Africa were demonstrated the high degree of
association.
Hui & Kwan (1994) used data from Asia-Pacific and
US equity prices to examine covariation among the
stock prices by employing factor analysis. Results
revealed that Japan, Taiwan, Hong Kong, and U.S
markets were categorized into different factors which
showed that these countries are suitable for
diversification. Naughton (1996) investigated the
correlation relationship between developed and Asian
markets by employing factor analysis. Low correlation
was found between developed and Asian markets. USA,
Hong Kong, and Australia are grouped in same category
but Japan and Korea were found in separate group.
Taiwan and Philippines were also located into a
separate factor. However, it was concluded that
potential diversification was available in Asian equity
markets.
Meric & Meric (1997) focused the period of pre crisis
and post-crisis of 1987 to verify the co integration of
European stock indices. Using factor analysis technique,
they reported that three factors were found statistically
significant before crash but after crash, only two factors
were shown in the analysis. These results suggest that
co movement among the markets is increased due to
crisis. Tuluca & Zwick (2001) used data of thirteen
equity markets to reveal the Asian crisis impacts on
international equity markets. Factor analysis technique
was applied and analysis reported that all markets other
than Asian markets were found into one factor, whereas
Asian equity markets were divided into two groups.
Therefore, the study suggested that potential
diversification was reduced as the case long-run
diversification.
Factor analysis technique was applied by Illueca &
Lafuente (2002) to examine the linkages among fifteen
international equity markets. The finding postulated that
four factors were generated through analysis for North
and South America, Asia, and Europe. Hui (2005) used
factor analysis to examine the potential benefits of
diversification for Singaporean investors using the data
of Asian Pacific markets including US market. The
findings suggested that big and developed markets such
as Australia, US, and Japan are relatively better for
Singaporean investors. Taiwanese stock market is also
used for diversification but Singapore, Thailand, South
Korea, Philippines, and Hong Kong market are not
beneficial for the reduction of risk. Valadkhani et al.
(2008) used Maximum likelihood and principal
component (PC) methodologies to explore the co
movements of stock market indices. Thirteen countries
monthly Stock returns data range from 1987 to 2007
was analysed by this study. Asian countries were falling
into first factor, where developed countries were
classified in the second factor. Consistency in results
was found in case of both ML and PC methods. It is
reported that Asian stock returns were showing high
correlation among themselves which reduces the
potential of diversification within these markets. In the
same way, the developed markets stock returns were
found to be highly correlated. Finally, findings suggest
that investor should make investment in both Asian
emerging markets as well as in the developed markets.
Hui et al. (2010) used data of eleven Asian equity
markets namely: Thailand, Taiwan, Singapore,
Philippines, Malaysia, New Zealand, Korea, Japan,
Indonesia, Hong Kong, and Australia as well as US
market to investigate portfolio potency by diversifying
the systematic risk of these economies. The result of
study was obtained by using factor analysis technique in
pre-crisis as well as post-crisis periods. It is suggested
that benefits of diversification were increase when
dividends are included in returns.
In the international Portfolio Theory (IPT), the key
determinant of optimal portfolio is that the correlation
between the securities must be negative or their
relationship should be weak. Cross economies
diversification can be achievable only when equity
markets are not moving very closely with each other. A
high return through minimizing risk in general can be
attained only unless stepping into broader diversification
(Bailey & Stulz 1990). Therefore, the results of this study
will beneficial to Asian portfolio investors. The finding of
study can be utilized for reduction of systematic risk
through going in diversified investments. However,
international portfolio diversification can be used as an
investment decision tool by most investors in the
investment world. There exist different motives for
investment in the various stock markets of the world of
which the most prominent among all is to earn a
reasonable return on investment. However, selecting
investments on the basis of returns alone is not
sufficient (Brodie, Daubechies & Loris, 2009). The fact
that most investors invest their funds in more than one
security suggests that there are other factors, besides
return, and they must be considered, investors not only
like return but on the other hand avoid or dislike risk and
this makes the financial market, despite the benefits and
rewards as a complexly volatile industry that requires
critical analysis to adequately evaluate risks relative to
returns to assist investors in decisions as regards
participation in the industry (Sabbadini, 2010).
Furthermore, international portfolio diversification theory
105
is a fundamental concept in which assets in an
investment portfolio are not to be selected individually
but rather how each of these assets changes in price
relative to how easy other asset in the portfolio changes
in prices as this can be consider as influence of
international portfolio theory on investment of a country’s
stock market.
Benefit of international portfolio diversification
Gains and impediments
There are several benefits that motivate investors to
invest in international portfolios. International evidence
on portfolio investment reveals that, through a greater
percentage of capital, invested in foreign equities,
investors will benefit from increasing their expected
return, decreasing the variation of their returns and
lowering the return correlations of foreign securities with
domestic securities (Grubel, 1968; Levy & Sarnat, 1970;
Solnik, 1974). Bartarm and Dufey (2001) revealed that
the attractions of investing internationally are based on
diversification effects, participation in the growth of other
foreign markets and abnormal returns due to market
segmentation.
The fact that returns on cross-border markets do not
move exactly in the same way all the times, will result in
diversification gains. However, understanding whether
the country factors or the importance of industry factors
cause this low correlation are still subjects of great
arguments among researches (Campa & Fernandes,
2006; Griffin & Karolyi, 1998; Rouwenhorst, 1999; Sean
et al., 2000; Serra, 2000).
The opportunity of participating in the fast developing
economies of emerging markets and consequently,
gaining tremendous values in a few years can be
considered as other benefits of international
investments. However, being stable with respect to
political risks is the salient advantage of capital markets
in industrialized countries such as Netherland or Japan
(Solnik & McLeavey, 2003).
Nevertheless, there are some barriers for
international
portfolio
investments.
Correlation
coefficients of market returns not only within developed
stock markets, but also between some mature emerging
markets that tend to increase slowly over time, it also
varies over time for obvious reasons (Longin & Solnik,
1995).
Besides, correlation coefficients increase
dramatically in the periods of crises, which denote that
diversification becomes useless in the exceptional times
when there is a huge loss on domestic investments.
Furthermore, issues such as: unfamiliarity with foreign
markets, political risk, market inefficiency, regulations,
transaction costs, taxes and currency risk might be
considered as examples of serious problems in respect
to international investment, particularly in less developed
countries (Solnik & McLeavey, 2003).
Advantages and disadvantages of international
portfolio diversification
Risk Reduction
When assets are widely diversified, the portfolio tends to
perform in a similar way to the market as a whole. If for
example, one own stocks in twenty different areas and
one of them takes a dive, it's unlikely that your portfolio
will suffer terribly. Diversification is the best way to
increase the stability of one investment and decrease
the risk of losing money in the event that a single area
decreases in value. Although diversification cannot
protect one from general market slowdowns, rather it will
maintain one portfolio's stability over time (Bekiros,
Nguyen, Uddin, & Sjo, 2015).
Asset Choices
When investors’ holdings are widely diversified, they can
spread them out over widely divergent forms of assets,
including securities such as stocks and bonds,
commodities such as oil and minerals, real estate and
cash. Each of these assets exhibits different strengths
and weaknesses in terms of risk and profitability.
Maintaining holdings in all of these areas helps to create
a stable portfolio that will increase in value over the long
term (Fabozzi, Fung, Lam, & Wong, 2013).
Disadvantage: Missed Windfalls
When investment holdings are widely diversified,
investors are unlikely to make a huge profit from a single
sector as to suffer a huge loss. However, if for example
a five percent of investors’ holdings suddenly spike, the
investor will make far less profit than if hundred percent
of the holdings were in that asset. In hindsight, many
investors have regretted diversification after a small
percentage of their holdings made a large profit.
However, it is very difficult to predict where and when
this will happen to an asset class or market sector, the
more tightly the investments are focused, the higher the
risk the investors’ are taking, which can lead to large
losses or to large gains (Andreasson, Bekiros, Nguyen,
& Uddin, 2016).
Disadvantage: Increased Exposure
If the market as a whole is declining, it is very likely that
investors’ holdings will do the same. When they diversify
their investments, they protect themselves from
excessive financial exposure, but at the cost of missing
out on potentially major profits (Reboredo, & Uddin,
2016).
Conclusion
While some controversy exists among investment
professionals regarding the benefits and costs of
International portfolio theory and diversification, there
are therefore enough empirical evidences that both
individual and corporate
international investors can
participate in the growth of other countries, hedge their
consumption basket against exchange rate risk, realize
diversification effects and take advantage of market
segmentation on a global scale (Bartram & Dufey, 2001;
106
Ruban & Melas, 2009; Burtless, 2006; Driessen &
Laeven, 2007).
There is agreement that international equity portfolio
diversification recommendations are based on the
existence of low correlations among national stock
markets. 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. Lower future correlation will provide
deeper risk reduction.
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.
Recommendations
Even though these advantages might appear attractive,
the risks and constraints for international portfolio
investment must not be overlooked. Investors must
employ strategic investment techniques to ensure that
they minimize risks and maximise returns. Particular
caution should be given to the choice of country; choice
of market; the correlation between the securities and
markets chosen; optimal portfolio weights; and portfolio
balance to obtain maximum diversification benefits. It is
crucial to ensure that portfolios are mean-variance
efficient, as the portfolio components derived from this
method are relatively stable. It might be most sensible
for the private investor to consider investing in
international mutual funds, preferably those that are
linked to a world capital market index (suitable indices).
Finally, this paper recommends that, all types of
investors should carefully research the stocks and
markets that they wish to invest in or ensure that they
employ the services of a reputable investment
management company.
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