International Diversification Versus Domestic Diversification: Mean-Variance Portfolio Optimization and Stochastic Dominance Approaches

Fathi Abid,Wing Wong,Pui Leung,Mourad Mroua

doi:10.3390/jrfm7020045

Abstract

This paper applies the mean-variance portfolio optimization (PO) approach and the stochastic dominance (SD) test to examine preferences for international diversification versus domestic diversification from American investors’ viewpoints. Our PO results imply that the domestic diversification strategy dominates the international diversification strategy at a lower risk level and the reverse is true at a higher risk level. Our SD analysis shows that there is no arbitrage opportunity between international and domestic stock markets; domestically diversified portfolios with smaller risk dominate internationally diversified portfolios with larger risk and vice versa; and at the same risk level, there is no difference between the domestically and internationally diversified portfolios. Nonetheless, we cannot find any domestically diversified portfolios that stochastically dominate all internationally diversified portfolios, but we find some internationally diversified portfolios with small risk that dominate all the domestically diversified portfolios.

Highlights

Despite greater integration of international capital markets, investors continue to hold portfolios largely dominated by domestic assets
Since most of the portfolios including both domestically diversified (DOD) and internationally diversified (IND) portfolios are rejected to be normally distributed, the results drawn from the portfolio optimization (PO) rule may be misleading
We first adopt the PO approach to examine the preferences of different DOD and IND portfolios for risk-averse investors

Summary

Introduction

Despite greater integration of international capital markets, investors continue to hold portfolios largely dominated by domestic assets. International investors’ preference for domestic stocks remains a subject of controversy, since many studies indicate that greater profits can be made by diversifying internationally. This paper applies the mean-variance portfolio optimization (PO) approach and the stochastic dominance (SD) test to examine preferences between domestic and international diversification strategies. Our study is based on daily data consisting of the prices of the 30 highest capitalization US stocks and 20 international market indices from Latin American and Asian financial markets and the G6. The purpose of this paper is to identify empirically preferences for international diversification versus domestic diversification from American investors’ viewpoints. Consider the utility-maximizing investor who holds two diversified portfolios: an internationally diversified (IND) portfolio and a domestically diversified (DOD) portfolio. The objective is to rank investors’ preferences in regard to these two types of diversified portfolios to maximize investors’ expected wealth and/or expected utilities

Objectives

Results

Conclusion