Are the Gains from International Portfolio Diversification Exaggerated? The Influence of Downside Risk in Bear Markets
Kirt C. Butler
Michigan State University
Domingo C. Joaquin
Illinois State University - Department of Finance, Insurance and Law
July 9, 2001
EFMA 2002 London Meetings
The fundamental rationale for international portfolio diversification is that it expands the opportunities for gains from portfolio diversification beyond those that are available through domestic securities. However, if international stock market correlations are higher than normal in bear markets, then international diversification will fail to yie ld the promised gains just when they are needed most. We evaluate the extent to which observed correlations to monthly returns in bear, calm and bull markets are captured by three popular bivariate distributions: (1) the normal, (2) the restricted GARCH(1,1) of J. P. Morgan's RiskMetrics, and (3) the Student-t with four degrees of freedom. Observed correlations during calm and bull markets are unexceptional compared to these models. In contrast, observed correlations during bear markets are significantly higher than predicted. Higher-than-normal correlations during extreme market downturns result in monthly returns to equal-weighted portfolios of domestic and international stocks that are, on average, more than two percent lower than those predicted by the normal distribution. If the extent of non-normality during bear markets persists over time, then a U.S. investor allocating assets into foreign markets might want to allocate more assets into foreign markets with near-normal correlation profiles and avoid markets with higher-than-normal bear market co-movements.
Number of Pages in PDF File: 26
Keywords: Bear markets; correlation; downside risk; portfolio diversification; financial markets; normal, RiskMetrics TM , GARCH, Student-t
JEL Classification: G15, G11, C15, C34
Date posted: May 12, 2000
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