The International Diversification Puzzle is Worse than You Think

24 Pages Posted: 14 Jun 2000 Last revised: 21 Sep 2010

See all articles by Marianne Baxter

Marianne Baxter

Boston University - Department of Economics; National Bureau of Economic Research (NBER)

Urban J. Jermann

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Date Written: February 1995

Abstract

Although international financial markets are highly integrated across the more well-developed countries, investors nevertheless hold portfolios that consist nearly exclusively of domestic assets. This violation of the predictions of standard theories of portfolio choice is known as the 'international diversification puzzle.' In this paper, we show that the presence of nontraded risk associated with variations in the return to human capital has dramatic implications for the optimal fraction of domestic assets in an individual's portfolio. Our analysis suggests that the returns to human capital are highly correlated with the returns to domestic financial assets. Hedging the risk associated with nontraded human capital involves a short position in national equities in an amount approximately 1.5 times the value of the national stock market. Thus optimal and value- weighted portfolios very likely involve a short position in domestic marketable assets.

Suggested Citation

Baxter, Marianne and Jermann, Urban J., The International Diversification Puzzle is Worse than You Think (February 1995). NBER Working Paper No. w5019. Available at SSRN: https://ssrn.com/abstract=225798

Marianne Baxter (Contact Author)

Boston University - Department of Economics ( email )

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Boston, MA 02215
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National Bureau of Economic Research (NBER)

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Urban J. Jermann

University of Pennsylvania - Finance Department ( email )

The Wharton School
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United States
215-898-4184 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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