INTERNATIONAL ASSET DIVERSIFICATION

Management Research Project Report Submitted

In Partial Fulfilment of
Master’s in Business Administration

By
KARTIK KAIN
MS17A025

to
Professor Prakash Sai L & Professor Madhumathi R
Department of Management Studies
Indian Institute of Technology, Madras

April 2019
 Declaration

This is to certify that Project Report entitled “INTERNATIONAL ASSET

DIVERSIFICATION” which is submitted by me, in partial fulfilment of the
requirement for the subject Management Research Project, to Department of
Management Studies, Indian Institute of technology, Madras comprises only my
original work and due acknowledgement has been made in the text to all other
material used.

Date: April, 2019 KARTIK KAIN

MS17A025

INTERNATIONAL ASSET DIVERSIFICATION | ii

 Acknowledgement

This research project is a part of the final year master’s programme. The writing
of this paper has been one of the most significant academic challenges that we
ever had faced.

I’m are indebted to my teachers Prof Prakash Sai and Prof Madhumathi; whose
encouragement, supervision and support from the beginning to the end level
facilitated me to develop an understanding of the subject. It would have been
next to impossible to complete it without her help and guidance.

I would also like to thank all the students and friends; it has truly been at
remarkable and valuable experience.

Lastly, we offer our regards and blessings to all of those who supported us in
any respect during the completion of the project.

INTERNATIONAL ASSET DIVERSIFICATION | iii

 Table of Contents
1. Introduction ...................................................................................................... 1

2. Literature Review .............................................................................................. 2

2.1 Portfolio Optimization .................................................................................................. 2

2.2 Stochastic Dominance .................................................................................................. 2

2.3 International v/s Domestic Diversification ................................................................ 2

3. Data, Methodology and Results .................................................................... 3

a. Portfolio Optimization ................................................................................................ 4

b. Stochastic Dominance ................................................................................................. 7

4. Conclusion ......................................................................................................... 9

5. The Dangers of Excessive Diversification ....................................................10

5.1 Problems with excessive diversification ................................................................... 10

5.2 Portfolio Rebalancing ................................................................................................. 11

6. Factors to take into consideration while diversifying ...............................11

6.1 Discussion of facts ...................................................................................................... 11

6.2 Analysis of the facts ................................................................................................... 12

INTERNATIONAL ASSET DIVERSIFICATION | iv

 Abstract

One of the ways to make sure that the business continues on its path of the Going
Concern Concepti is to hedge it against the risk faced by it in the dynamic
environment. However, just hedging against the risk will not make sure that the
company continues to earn revenue and prosper. Executives are extensively
looking out for opportunities to expand their businesses and diversification is one
of the most widely accepted and implemented the approach. However, the answer
has always been ambiguous as diversification can prove itself to a double-edged
sword.

According to the portfolio theory by Markowitz ii (1952), the diversification of

the portfolio is beneficial only when the correlation among the assets in which
the investments are made is low or preferably negative. From this fact, it is
derived that in the case of interlinked markets, these links are wiped off.

Therefore, an analysis of relationships between the markets will facilitate global

investors in reaching a better investment decision. So as to be in an advantageous
situation, one should invest if these two markets are uncorrelated or weakly
correlated. An increased amount of capital, both long and short run started
happening on a huge scale ever since the economies of several countries have
removed their shackles of investments. Another critical area to be evaluated is
the efficiency of these markets.

This study aims at a comparison between International Asset Diversification and

Domestic Asset Diversification using proven techniques of Mean-Variance
Portfolio Optimization and Stochastic Dominance by taking examples from the
Indian and American Stock Market.

Also, we will throw some light on whether International Investment

Diversification Prudent to Either the Individual or Corporate Investor and why in
the later part of the research paper.

iThe Going Concern Concept Of Accounting Implies that the business entity will continue its
operations in the future and will not liquidate or be forced to discontinue operations due to any
reason

INTERNATIONAL ASSET DIVERSIFICATION | v

ii Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper
"Portfolio Selection," (published in 1952 by the Journal of Finance)

INTERNATIONAL ASSET DIVERSIFICATION | vi

 1. Introduction

“Diversification is a risk management technique used in finance which reduces the risk of investment
by investing in different investment tools (stocks, bonds, mutual funds, real estate, and so on) and
increases the chance of making profits. With the integration of the capital market all over the globe,
the concept of asset diversification has come into play. Investors from all fields are not only investing
in the domestic markets but also in international ones.

International diversification has been appreciated and accepted by many renowned researchers and
academicians as an effective way to achieve higher risk-adjusted returns than domestic investment
alone. The main focus here is the underlying strategy that international stocks tend to display
significantly low levels of correlation than stocks/assets trading on the domestic market.”

This rising trend of integration of global capital markets in international diversification of investment
has its roots in the theory suggested by Grubel in 1968 which focussed on the concept of modern
portfolio analysis, initially initiated by Markowitz (1952) and Tobin (1958). The theory suggests that
international portfolio diversification leads to significantly different world welfare gains.

This led to numerous other theories such as Solnik (1974) and Lessard (1976) which further promoted
this idea. These scholars proved that there are other numerous probable possibilities that make an
investors to adopt international diversification to gain higher returns on their investments. Adding to
that, the Maximum Diversification Portfolio which was introduced by Choueifaty and Coignard in
2008 also aimed at maximising a metric which defines the degree of portfolio diversification and
thereby highlighted the fact that portfolios which have low correlated asset and lower risk levels yield
higher returns than traditional portfolio strategies.

The proposed benefits are the motivating factors which drive to engage an investor in internalization
which include a number of factors like active participation in the growth of foreign markets; hedging
of the investor's consumption just beside the risk and reward; This is study was concluded by Bartram
& Dufey in 2001. This was later called as International Investment Diversification (IID) or
International Portfolio Investment (IPI).

Even after the compelling advantages of the asset diversification; it is very well seen that most
investors fail to take full advantage of the situation and in-turn favour to focus their investments
limited to their home country (Ruban & Melas, 2009). For example, In one of the study conducted
by Cooper and Kaplanis (1994) on United Kingdom investors stated that the investors place 78.5%
of their equity portfolios in domestic equities, and only a mere 10.30% of them put a fraction of their
investments in international market capitalization.

Hence, this study aims to unfold the answers the following questions;

• Should one aim at International Asset Diversification as to gain higher return and minimise the risk
associated with it?
• What are the factors which needs to be taken into consideration when an investor is planning to go
global in their investments?
• And lastly, is International Asset Diversification Prudent to just an Individual or Corporate Investor
too?

INTERNATIONAL ASSET DIVERSIFICATION | 1

 2. Literature Review

2.1 Portfolio Optimization

The much appreciated mean-variance portfolio optimization theory and model introduced by
Markowitz is widely used to determine the asset allocation for the capital investment one makes,
however, it departs from the theoretical optimal return. As to overcome this limitation, Bai, Liu and
Wong further took the study by developing a bootstrap estimate for the optimal return of self-financing
portfolios and proved that the these estimates are proportionally consistent complements their
theoretical counterparts. Taking this ahead, they also developed a few properties for their estimators.
In addition to this, Leung, Ng, and Wong further improve the estimation by deriving explicit formulas
for the estimator of the optimal portfolio return and proved that their closed-form return estimator is
consistent.

Most of the work on portfolio theory is based on the assumption that utility function is a second-degree
polynomial with a positive first derivative and a negative second derivative, or the probability
functions are normal which are based on the utility maximization principle. Glen and Jorion and others
used the Mean-Variance (MV) analysis to investigate the benefits of international diversification
purely based on a risk/return measurement.

In spite of its popularity, the Mean-Variance approach has been subject to serious criticism as well.
For example, Wong has shown that the MV preference is justified to utility maximization if the assets
in concern are being compared belong to the same location-scale family or the same linear combination
of location-scale families and brought out a major flaw in the method.

2.2 Stochastic Dominance

The SD approach has been regarded as one of the most useful tools for ranking investment
prospects since the ranking of assets has been shown to be equivalent to utility maximization for
the preferences of risk appetite of the investor.

To overcome the limitations of the MV approach, it is suggested by many scholars that an investor
much use Stochastic Dominance (SD) as it proves that it provides a framework for evaluating portfolio
choice without benchmarking the asset prices. As it does not need any assumption on the distribution
of the assets being examined, it satisfies the general utility function and takes into consideration all the
distributional moments while comparing.

This theory has also been tested by many scholars such as Hodges and Yoder used this technique to test
whether there’s any relationship between the risk of the securities and the time horizon an investor takes
into consideration. Meyer, Li and Rose used it to test whether adding international assets to a whole
domestic portfolio generates any advantages or benefits for an investor (this study was confined to New
Zealand only). Lean, Smyth and Wong used the SD test to find any evidence of seasonality (weekly and
monthly) effects in some of the Asian markets.

2.3 International v/s Domestic Diversification

Multiple studies have been made to know the benefits of the diversification strategies. Stating
examples, Solnik showed us how substantial advantages can be attained through portfolio
diversification in foreign securities as well as in domestic common stocks by risk reduction. On the
similar lines, Eun and Resnick found potential gains made by international diversification. Meyer and
Rose found that international diversification can be advantageous in the times of crisis in the developed

INTERNATIONAL ASSET DIVERSIFICATION | 2

markets. Carrieri, Errunza, and Sarkissian showed us how cross-country/industry can help us to
improve the performance of the portfolio.
On the other hand, French and Poterba showed us that many investors hold their entire wealth (not
completely) in domestic assets. Lewis taught us that domestic hedging can be beneficial when
compared to international diversification. Kilka and Weber showed that actual equity portfolio
holdings revealed a stronger bias toward domestic stocks and concluded that this bias can be explained
by the stock return expectations expressed in probability judgments. Antoniou, Olusi, and Paudyal
examined whether British investors needed 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.

3. Data, Methodology and Results

To analyse the preferences of the domestic and international diversification of the portfolios, we have
taken the yearly arithmetic returns of the closing prices of 50 countries from 1997 to 2017. The data
used to evaluate the above mentioned has been taken from World Bank.

We use the yearly closing prices of these 50 countries (Table 1) to form several domestically
diversified portfolios. As to form the internationally diversified portfolio, we use yearly stock market
indices from the following countries:

Argentina Italy
Australia Jordan
Austria Japan
Belgium Latin America & Caribbean Developing
Brazil Sri Lanka
Canada Mexico
Switzerland Malaysia
Czech Republic Nigeria
Germany Netherlands
Developing Countries Norway
Denmark Peru
Spain Philippines
Finland Poland
France Portugal
United Kingdom Russian Federation
Greece Saudi Arabia
High Income Countries Singapore
Hong Kong SAR, China Slovakia
Croatia Sweden
Hungary Thailand
Indonesia Tunisia
India Turkey
Ireland Taiwan, China
Iran, Islamic Rep. Ukraine
Israel United States
Table 1: List of selected countries.

INTERNATIONAL ASSET DIVERSIFICATION | 3

Further, we have taken all the figures in Dollars to avoid the exchange rate biases.

From the perspective of an investor, we adopt Portfolio Optimization and Stochastic Dominance
approaches to compare the performances of the internationally diversified and domestically diversified
portfolios. The following subsections provide an extensive view on the same.

a. Portfolio Optimization

We first adopt the classical optimization model to determine the fraction of a given capital invested in
each country of a portfolio with its expected return being maximized subject to obtaining a pre-
determined level of variance (risk).

The method to do calculate the various levels of risk and return is discussed below:

1. Calculate the arithmetic mean and standard deviations of the yearly returns for all the 50 countries.

2. Find the covariance between the countries stock market yearly returns and build a matrix.

3. Find the maximum and minimum returns from the 50 countries used for evaluation. This gives you
the upper and lower bound of the diversified portfolios. In our evaluation, the lowest return is from
Portugal (1.069%) while the highest is from Argentina (23.838%).

4. Then we use Excel Solver to find the various weightages one needs to assign to gain a particular
standard of returns along with the risk associated with it and Sharpe Ratio.

5. Once we have them, we list it and find the optimal point of return using Capital Market Line and
Risk where an investor gets the maximum return with a specific risk which ensures that the investor
is making the maximum money with the level of risk associated with it. This is the point which is
the optimal point of return as per the Markowitz Model.

The following table summarises the Return, Risk (Standard Deviation) and the Sharpe ratio.

Return Standard Deviation Sharpe Ratio

5.00% 10.19% 0.49
5.50% 9.49% 0.58
6.00% 8.87% 0.67
6.50% 8.62% 0.75
7.00% 8.89% 0.79
7.50% 9.20% 0.81
8.00% 9.57% 0.83
8.50% 10.00% 0.85
9.00% 10.47% 0.86
9.50% 10.87% 0.87
10.00% 11.37% 0.88
10.50% 11.90% 0.88
11.00% 12.47% 0.88
11.50% 13.07% 0.88
12.00% 13.70% 0.87
12.50% 14.34% 0.87

INTERNATIONAL ASSET DIVERSIFICATION | 4

 13.00% 15.01% 0.86
13.50% 15.69% 0.86
14.00% 16.37% 0.85
14.50% 17.08% 0.85
15.00% 17.80% 0.84
15.50% 18.54% 0.83
16.00% 19.29% 0.83
16.50% 20.06% 0.82
17.00% 20.84% 0.81
17.50% 21.62% 0.81
18.00% 22.42% 0.80
18.50% 23.24% 0.80
19.00% 24.11% 0.79
19.50% 25.04% 0.78
20.00% 26.05% 0.77
20.50% 27.17% 0.75
21.00% 28.40% 0.74
21.50% 29.72% 0.72
22.00% 31.12% 0.71
22.50% 32.59% 0.69
23.00% 34.13% 0.67
23.50% 35.75% 0.66
23.84% 37.02% 0.64

Table 2: Risk and Return

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00%

Figure 1: Markowitz Efficiency Frontier for 50 countries

INTERNATIONAL ASSET DIVERSIFICATION | 5

To dig further into the research, we divided the countries in terms of developed and developing
countries using the data provided by the International Monetary Fund (IMF), World Economic
Outlook Database, October 2018.

• The developed countries have been selected on the basis of ‘advanced countries’ as per IMF.
• The developing countries have been selected from the link: "World Economic Outlook, October,2018,
pp.134-135"

By keeping a constrain in mind, an investor can only invest in the developed countries or in developing
countries, efficiency frontiers are found for them and the results are as follows:

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00% 45.00%

Figure 2: Developing Countries Efficiency Frontier

20.00%

18.00%

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

Figure 3: Developed Countries Efficiency Frontier

INTERNATIONAL ASSET DIVERSIFICATION | 6

While comparing the 3 efficiency frontiers in the research, the returns earned in the developing markets
by the investors is the best of all the three.

Segregation Return Sharpe Ratio

All 10.50% 0.88
Developing Countries 12.50% 0.87
Developed Countries 7.50% 0.65
Table 3: Risk-Return of the efficiency frontiers.

With a return of close to 12.50% with a Sharpe Ratio of 0.87, the investors can expect to receive more
excess return for the extra volatility they are being exposed to by holding the portfolio when they are
building a portfolio in the developing countries.

b. Stochastic Dominance
To overcome the limitation of traditional MV criteria, the stochastic dominance approach developed
by Hadar and Russel, Hanoch and Levy and others is one of the most useful tool in ranking investment
prospects under certainty. Let X and Y denote the domestic and international portfolios with their
Cumulative Distribution Functions (CDFs), F and G, and their probability density functions (CDFs)
as f and g respectively, defined on the common support of [a,b] with a < b.

From the above Table 3, we can see that an Indian investor can earn a lot more by investing at a global
level and therefore, the international portfolio dominates the domestic portfolios. Where an Indian
investor would have got a return of 0.83% in an average for the time horizon taken in the study (2007-
2017), the internationally diversified investments would have given him a return of 10.50%. Also, the
Sharpe Ratio for domestic investments is 0.12, the international investments have a ratio of 0.88.

Average Return 0.83%

Standard Deviation 6.68%
Risk-Free Rate 0.02%
Sharpe Ratio 0.12
Table 4: Return, Standard Deviation and Sharpe Ratio for Domestic Investments (India)

Hypothesis:
• For First Order
o Null Hypothesis: International Portfolios first order stochastically dominates the
Domestically diversified Portfolios.
o Alternate Hypothesis: : International Portfolios doesn’t first order stochastically
dominates the Domestically diversified Portfolios.
• For Second Order
o Null Hypothesis: International Portfolios second order stochastically dominates the
Domestically diversified Portfolios.
o Alternate Hypothesis: International Portfolios doesn’t second order stochastically
dominates the Domestically diversified Portfolios.

First Order Stochastic Dominance: X dominates Y, denoted by X>Y, or F>G, if F(x) ≤ G(x), for
all x and strictly inequality holds for at least one value of x. This is stochastic dominance for risk
seekers or the ones who want higher returns. On the contrary, the worst return is the best return for
the investors who are risk averters.

INTERNATIONAL ASSET DIVERSIFICATION | 7

Here, without taking into consideration the risk preference, the international diversified portfolios
can give returns much higher than the domestic portfolios.

The returns from the internationally diversified portfolios can range from 1% to 23.84% where the
average return for an Indian investor in the 21 years of data used in the research is 10.541%,
however, they could have earned much more than that if the portfolios were internationally
diversified.

Taken the case of other countries, the international portfolios can first order stochastically
dominate the domestic portfolios for all the countries apart from Argentina where the investors can
be neutral towards the selection of global investments as both of the portfolios provide similar
returns (at 23.84%)

Cumulative Distribution Functions

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

CDF INT CDF DOM

If the internationally diversified portfolio first order dominates the domestic portfolio, then the
CDF of international investments should be above the domestic completely. However, here, is not
the case. Therefore, internationally diversified investments doesn’t first order stochastically
dominates the domestic portfolios. Hence, we reject the null hypothesis.

Second Order Stochastic Dominance: X (international portfolios) dominates Y(domestic

portfolios) if and only if the investor weakly prefers F (CDF of X) over G (CDF of Y) under every
weakly increasing concave utility function, considering they have the same mean, that is, the
returns from both the portfolios are the same.

Now as we didn’t get any one portfolio to invest and the answers aren’t clear, therefore, we perform
the second order stochastic dominance test to give us the best choice from the two options in
evaluation here.
To comment more on the same, we assume that an investor is risk averse and thus have a utility
function of positive economic return but with a decreasing slope. X is preferred over Y if the
𝑥 𝑥
formula holds true for all values of x and ∫−∞ 𝐹𝑋 (𝑥)𝑑𝑥 ≤ ∫−∞ 𝐹𝑌 (𝑦)𝑑𝑦

INTERNATIONAL ASSET DIVERSIFICATION | 8

Therefore, frequency distributions of outcomes of alternatives are compared based on the areas under
their cumulative distribution functions. Second Order Stochastic Dominance requires that the curve of
dominant cumulative distribution that is the best choice, lies everywhere below and to the right of the
other alternatives.

Now as to prove second order stochastic dominance, we compare the area under the cumulative
distribution graphs of both the portfolios. If the area of the Internationally diversified portfolio is
smaller than the Domestic portfolio, we can say that International diversified portfolio second order
stochastically dominates the domestic portfolio.

Referring to the Excel for second order stochastic dominance, the answer to the above mentioned
criteria is -0.046598301. This states that for all the risk averse investors, international portfolio is
𝑥
preferred and second order stochastically dominates the domestic portfolio, also, ∫−∞ 𝐹𝑋 (𝑥)𝑑𝑥 ≤
𝑥
∫−∞ 𝐹𝑌 (𝑦)𝑑𝑦 holds true.

4. Conclusion

In this paper, we compare the performances of the efficient internationally and domestically
diversified portfolios by applying both, the efficiency frontier and stochastic dominance approach to
analyse the financial markers of 50 nations from 1997 to 2017.

While comparing the efficiency frontiers, we find that one strategy could dominate the others over a
range of risk and return. Our results show that the investors who are willing to take higher risk,
international asset diversification can provide them higher returns, whereas, for a risk averse person
(Indian investor), domestic diversification can suffice the returns one has aimed at.

Going forward, we divided the data into developing and developed nations and compared the
efficiency frontiers of all three. The results are concluded in Table 3 and the efficiency frontier of the
developing nations provided the highest efficient return at a very high Sharpe ratio which makes it the
best efficient frontier out of the three compared.

To dive deeper, we also did stochastic dominance test and tried to test the dominance of one portfolio
over the other, in other words, whether international portfolios stochastically dominate the domestic
ones. The results showed that neither of them first order stochastically dominate the other as the graphs
of the cumulative distribution functions intersect. This proves that one doesn’t dominate the other. To
find answer for further questions, we performed second order stochastic dominance and found that the
international portfolios does second order stochastically dominate the domestic ones as
𝑥 𝑥
∫−∞ 𝐹𝑋 (𝑥)𝑑𝑥 ≤ ∫−∞ 𝐹𝑌 (𝑦)𝑑𝑦 held true, where International portfolios are denoted by X and domestic
ones are denoted by Y. Nonetheless, we can’t say that Indian Stock market portfolios stochastically
dominates the international ones but we found that the internationally diversified portfolios with
smaller risk than the domestic ones. This support the claim that the internationally diversified
portfolios are than the domestic ones. However, our findings imply that international diversification
is better at lower risk level, the market for the domestic and international diversification strategies are
efficient when they have the same risk level.

We summarise the main findings as the following:

INTERNATIONAL ASSET DIVERSIFICATION | 9

1. Internationally diversified portfolios can provide better returns considering that the investor can
take risks.
2. International portfolios doesn’t first order stochastically dominate the domestic ones.
3. As per the second order dominance, international portfolios are preferred for risk averse investors.

As an extension of the study, one could include examining the preferences of different kind of
investors, such as risk seekers and evaluate the different kind of utility functions behavioural financial
models could be used to examine the behaviour of different investors when deciding whether to invest
internationally or domestically.

5. The Dangers of Excessive Diversification

“The pros of excessive diversification have been drilled into the hearts of financial professionals,
however, excessive diversification is hardly discussed or talked about. It is finally an individual
position that matter, and despite what some scholars would have make us believe, the aggregate quality
of a given portfolio cannot exceed the underlying individual quality of the specific components - if
you're sitting on a pile of junk, adding more junk isn't going to keep you meaningfully safer.”

“Don’t keep all your eggs in one basket” is the underlying layman principle when it comes to
diversification however, the trick is not to take it too far and to pay attention while assigning
weightages smartly when an investor measures the risk and return. But the real question one has to
answer is “How much diversification is excessive in a portfolio?”

As per multiple studies in this domain, an average investor ideally shouldn’t hold more than twenty
or thirty well-chosen, defensively selected common stocks, which corresponds to an individual
component weight of 3.33% to 5.00%; the investment shouldn’t exceed to more than a hundred
stocks.

5.1 Problems with excessive diversification

Excessive diversification beyond this point (especially for non-professionals who lack the resources
and time necessary to regularly monitor the operating performances) has the following problems:

• Excessive Diversification Lowers The Investment Standards – At times investors are likely to
add anything and everything to their portfolio, they tend to lose out the well-established,
conservative standards and thereby accept risk. As each position represents a smaller capital
commitment, the risk-return standard established by one tends to be overlooked.
• Excessive Diversification Might Cause Neglect – When an investor diversifies extremely, it
becomes very difficult to keep a track of each and every detail on every investment. Most of the
time these changes, if not noticed, can even destroy the intrinsic value of the investments.
• Excessive Diversification Might Cause Dilution – With excessive diversification, even the best
asset gets unnoticed and its impact too is overlooked as it forms a very small proportion of the
total portfolio.
• Excessive Diversification Increases the Cost of Investment - Although this isn't really a concern
once the investors surpass a significant amount in investable asset line when trading costs and
other expenses become a much smaller percentage of the overall portfolio and even low
commissions of $10 or less per trade can add up to a big amount if you're dealing with multiple
positions.

INTERNATIONAL ASSET DIVERSIFICATION | 10

 5.2 Portfolio Rebalancing
On a general note, one shouldn’t take a short position on any asset or stock by just looking at the
capital gains. One should always look out for ways of ‘rebalancing’.
Alignment of the goals of a company or personal goals with the investment is the bare minimum for
any investor. Therefore, if the short term or long term goals of the business such as margins, growth,
competitive position, management, etc., have not changed, and the price appears to be reasonable, it
will be a foolish move to sell the holding and buy any other asset which doesn’t represent the current
goals even if it will increase the value of the portfolio significantly.

Famed money manager Peter Lynch called this practice, “cutting the flowers and watering the
weeds.” Billionaire investor Warren Buffett tells us that, “the most foolish maxim on Wall Street is,
"you can never go broke taking a profit’.”

There is only one primary rule of investing: In the long run, business fundamentals will determine the
success of your holding if the security was purchased at a reasonable price.

However, sometimes the goals of the business are to reduce the risk and not increase the absolute
return. In this case we make an exception to the above mentioned tactic. No matter how great the
opportunity seems to be but when an investor is not comfortable in diluting its portfolio, the tactic
gives no advantage to them.

6. Factors to take into consideration while diversifying

6.1 Discussion of facts

1. Risk and Reward:

The basic outcome of the International Investment Diversification is to reduce the total risk of the
portfolio while offering potential additional returns or rewards. Also, it helps to improve the risk
adjusted performance of the portfolio. An investor therefore aims to achieve a well-diversified profile
because of the amount of funds are large enough for in-house or domestic diversification. Here mutual
funds offer a quicker and relatively inexpensive way to diversify for the small investors compared to
institutional investors. Now, as the investment horizon and economies of the countries differ from
each other, it paves a way for the international diversification. In fact, the year 1990 witnessed a boom
in the trend of diversifying assets internationally in many emerging economies. These claims have
been proved by Burtless and Yavas in 2006 and 2007 respectively.

Adding foreign bonds in one profile sounds attractive from a ‘risk-return’ perspective because of the
low correlation with the domestic market. However, adding debt and corporate bonds might not help
the investor in achieving the diversification benefits fully. But if these bonds are hedged by the
currency derivative, then significant benefits from the emerging markets can be attained from the
viewpoint of a developed market investor.

Adding international assets is worthwhile if considered over a wider time horizon as the value adding
been made as to calculate the ‘significant’ time horizon. A UK based study proves that international
investing over the last decade has provided higher returns at lower risks where the investment has been
made over 1, 3, 5 or 10 years. (Ruben et al., 2009).

2. Diversification:

INTERNATIONAL ASSET DIVERSIFICATION | 11

Straus (2005) reported in a study that $84 billion was invested in the foreign markets as compared to
a figure of $84 billion in the US market. This shows a healthy shift of the investors from domestic
market towards international markets. But the catch here is that one shouldn’t just go ahead and start
investing in the international market without careful analysis of the performance. As there has been a
rising trend in the US, Indian investors are too moving towards international diversification through
mergers and acquisitions mainly. However, countries like Australia, Sudan, United Arab Emirates
(UAE), Singapore, Mauritius, Netherlands and British Virgin Islands have certainly attracted the
Indian investors.
“According to the data provided by Reserve Bank of India (RBI), India’s outward Foreign Direct
Investment (OFDI) in equity, loan and guaranteed issue stood at US$ 11.33 billion in 2017-18 and
US$ 1,093.6 million in October 2018”

6.2 Analysis of the facts

1. Risk and Reward

Despite the fact that international diversification, if applied properly, can result in excessive returns.
However, there are many other factors which can result in lower returns that expected or calculated.
These factors include low performance of foreign markets which can hamper the financial plans of the
investors who are planning for their retirement even when the domestic market has been providing
excellent returns. Therefore, careful evaluation is a must before opting for international diversification
(Burtless, 2006).

As the ultimate objective of any investment is to maximise the gains by lowering the risks involved,
however, there are many factors that one needs to carefully evaluate and assess. This rule applies to
retail investors and institutional investors with varied risk appetite. As to overcome this hurdle, mean-
variance analysis of the portfolio is advised. Also, the international are prone to many other factors
like exchange risk, political risk, barriers to trade and complexities of the tax issues. Therefore, an
efficient plan of action should be made before making any impulsive decisions related to investments
(Bartnam & Dufet, 2001).

2. Diversification

Globalization which is mainly characterised by movement of goods, capital and other factors has made
its impact on international investments. The same is to such an extent that even when investors are not
going international with their investments, globalization is affecting the returns and
hampering/improving the performance of their portfolio. The logic behind the same is that the
companies in which the investors are investing have their operations overseas or are making
investments globally.

INTERNATIONAL ASSET DIVERSIFICATION | 12

 References:

1. Markowitz, H. Portfolio Selection. J Financ. 1952

2. International Diversification Versus Domestic Diversification: Mean-Variance Portfolio
Optimization and Stochastic Dominance Approaches. Fathi Abid, Pui Lam Leung, Mourad
Mroua and Wing Keung Wong. 2014
3. Mutual Fund Style Analysis: A Stochastic Dominance Approach. Jeu Ren 2017.
4. Stochastic dominance and behavior towards risk: The market for Internet stocks. Journal of
Economic Behaviour and Organisation. 2008.
5. Mapping the value of diversification. Francisco Caudillo, Skief Houben, and JehanZeb Noor.
2015
6. A review on international portfolio diversification: The Middle East and North African
region. Gholamreza Mansourfar, Shamsher Mohamad and Taufiq Hassan. 2010
7. International Portfolio Diversification is better than you think. Nicolas Coeurdacier and
Stephane Guibaud. 2010
8. Global Equities: Balancing home bias and diversification. Vanguard Research. 2014.
9. Stochastic Dominance. Diderik Lund. 2012.
10. Thriving in the abnormal. A McKinsey & Company Research. 2016.
11. Stochastic Dominance. MIT Research. 2010.
12. Stochastic Dominance and Investors’ Behavior towards Risk: The Hong Kong Stocks and
Futures Markets Kin Lam and Hooi Hooi Lean and Wing-Keung Wong. 2016
13. International diversification in portfolio investments of institutional investors. Tomi Rilo.
2000.
14. The Cumulative Distribution and Stochastic Dominance. Daniel A. Graham. 2011
15. The maximum diversification investment strategy: A portfolio performance comparison.
Ludan Theroy and Gary van Vuuren. 2018 .

INTERNATIONAL ASSET DIVERSIFICATION | 13