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Are the Gains from International Portfolio Diversification Exaggerated? The Influence of Downside Risk in Bear Markets

26 Pages Posted: 12 May 2000  

Kirt C. Butler

Michigan State University

Domingo C. Joaquin

Illinois State University - Department of Finance, Insurance and Law

Date Written: July 9, 2001

Abstract

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.

Keywords: Bear markets; correlation; downside risk; portfolio diversification; financial markets; normal, RiskMetrics TM , GARCH, Student-t

JEL Classification: G15, G11, C15, C34

Suggested Citation

Butler, Kirt C. and Joaquin, Domingo C., Are the Gains from International Portfolio Diversification Exaggerated? The Influence of Downside Risk in Bear Markets (July 9, 2001). EFMA 2002 London Meetings. Available at SSRN: https://ssrn.com/abstract=221992 or http://dx.doi.org/10.2139/ssrn.221992

Kirt C. Butler (Contact Author)

Michigan State University ( email )

315 Eppley Center
East Lansing, MI 48824-1122
United States
517-432-0035 (Phone)
517-432-1080 (Fax)

Domingo Castelo Joaquin

Illinois State University - Department of Finance, Insurance and Law ( email )

Normal, IL 61790
United States
(309) 438-2258 (Phone)
(309) 438-5510 (Fax)

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