Multinational Finance, 6th Edition

Chapter 19International Portfolio Diversification

I have no doubt that in reality the future will be vastly more surprising than anything I can imagine. Now my own suspicion is that the universe is not only queerer than we suppose, but queerer than we can suppose.

— J.B.S. Haldane, Possible Worlds and Other Papers

This chapter provides the rationale for diversifying investment portfolios across national borders. Despite the predictions of theory, investors exhibit a strong preference for assets from their home market. This home bias is at least partly due to the many barriers that investors face in distant and unfamiliar markets. Foremost among these are informational barriers that impede foreign investors from knowledgeably pricing and investing in local assets. Despite these barriers to cross-border portfolio investment, international diversification is increasingly accessible to investors around the world.

19.1 The Algebra of Portfolio Diversification

In 1990, Harry Markowitz and William Sharpe were awarded the Nobel Prize in economics for their work in portfolio theory and asset pricing. The insight at the heart of their work is quite simple. Markowitz and Sharpe observed that investors are concerned with the expected return and risk of their portfolio of assets, not with the return or risk of any single asset in isolation. An understanding of this portfolio perspective will allow us to appreciate the implications of this insight for asset prices in a global marketplace, ...