Ask Dr. Econ

July 1999

An analyst recently indicated that "putting all your eggs in one basket" isn't a good investment strategy and instead recommended diversification across world markets as a way to reduce risk. However, when inflation fears in the U.S. rise, world stock markets tumble, suggesting the two are linked. Furthermore, if the recovery in Asia is dependent on strong U.S. demand for Asian products, how can the portfolio of an international investor be diversified?

There is a body of empirical evidence that indicates that a diversified portfolio of securities, for example 20 randomly selected stocks, holds much less risk (measured by the standard deviation of returns) than an individual security. This follows because:

• The standard deviation of returns from a single stock in a portfolio is much larger than the standard deviation of the entire portfolio.
• The standard deviation of returns on a portfolio declines as the number of stocks in the portfolio rises towards 20.

An important result of holding a diversified portfolio is that:

• A diversified portfolio follows the market very closely, while an individual stock or a portfolio of stocks from a single industry may not closely follow the overall market.

In a similar manner, worldwide diversification, adding some international stocks to the portfolio, may further reduce risk, if:

• Movements in international stock markets are not perfectly correlated.
• Correlations of the returns between international stock markets are positive; investors can benefit by spreading their investments across multiple markets.

As your question notes, there are some linkages between real economic conditions and stock market performance across countries. However, the performance of these markets in any country will vary based on both domestic and international factors, so that market performance will not be perfectly correlated across countries. This creates potential for benefiting from international diversification.

Note: The standard deviation of portfolio return may be broken down into two components. The first component, unsystematic risk, may be eliminated through diversification. The second, systematic or market-related risk, may not be eliminated through diversification. The combination of these two-risk components is called total risk. Diversification (holding many securities) may eliminate the unsystematic risk from a portfolio.

References

Fabozzi, Frank J., Franco Modigliani, Michael G. Ferri. 1994. Foundations of Financial Markets and Institutions. Englewood Cliffs, NJ: Prentice Hall Inc.

Kasa, Kenneth. 1994. "Measuring the Gains from International Portfolio Diversification." FRBSF Weekly Letter 94-14 (Apr 8).

Personal Financial Education, FederalReserveEducation.org, 2003