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
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
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.
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).
Education, FederalReserveEducation.org, 2003