Risk Reduction by Diversification in the Nordic Stock Markets

Abstract

Empirical examination of the ex post potential gains of risk reduction through international portfolio diversification started with Grubel (1968), Levy and Sarnat (1970), Solnik (1974) and Lessard (1974). In their survey of international finance, Adler and Dumas (1983, p. 938) summed up the results: potential for international diversification to reduce risk seems unquestionable. In the wake of increasing liberalization for international portfolio investment, more recent contributions include Jorion (1985, 1989), Grauer and Hakansson (1987) and Levy and Lerman (1988). The results of the pioneers have been corroborated by contemporary research and, according to Jorion (1989, p. 54): International diversification, extolled by Grubel as early as 1968, seems to have delivered on its promises. Despite the long tradition of studies in international portfolio diversification, there has been no such work regarding the Nordic markets. This paper fills the gap through an analysis of potential gains from international diversification for different Nordic investors (Danish, Finnish, Norwegian and Swedish) if they invest in all the Nordic equity markets. Until the beginning of the 1980s, Nordic investors, particularly in Finland and Sweden, faced legal restrictions on investment abroad; see Nordiska Radet (1987). Adler and Dumas (1983) have pointed out that such restrictions would lead to partially or fully segmented markets, and Hietala (1989) has shown the existence of premiums in the Finnish stock market. In our study we do not make any direct test of whether the Nordic equity markets have been segmented or integrated, but our results might provide some indirect evidence. The Nordic countries are generally viewed as fairly homogeneous from a social, political and economic point of view, while international diversifi-