Potential Gains from International Diversification: Cross-Country Evidence from an Alternative Methodology

Abstract

I examine the international diversification gains from the perspective local investors using MSCI index data for 48 stock markets. I implement a framework recently proposed by Rudin and Morgan (2006, Journal of Portfolio Management). Based upon a principal components analysis run over the covariance matrix, the “Portfolio Diversification Index” resumes the diversification potential across an investment set via a single statistic without requiring any statistical inference regarding the returns expectations. Evidence is globally in favor of the potential gains from global diversification for local investors in each country. Unlike the results obtained from the mean-variance framework, the diversification gains does not differ significantly across local investors in developed and emerging markets. The costs from home bias are sizeable in that for relatively low levels of the domestic investment share by 15-20%, the resulting international portfolio exhibit an almost undiversified pattern. I also examine the dependence of the diversification potential as local investors enlarge the international portfolio pool. Remarkably, the marginal gains from adding one more foreign destination drop sharply as the portfolio size increases. For most cases, an international portfolio made up by 40 stock markets yields the same diversification scheme which would be obtained via a medium-sized portfolio consisting of 10 to 15 markets.