Global Portfolio Diversification for Long-Horizon Investors

80 Pages Posted: 27 Mar 2017  

Luis M. Viceira

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Zixuan (Kevin) Wang

Harvard Business School

John Zhou

Harvard University

Date Written: March 2017

Abstract

This paper conducts a theoretical and empirical investigation of the risks of globally diversified portfolios of stocks and bonds and of optimal intertemporal global portfolio choice for long horizon investors in the presence of permanent cash flow shocks and transitory discount rate shocks to asset values. We show that an upward shift in cross-country one-period return correlations resulting from correlated cash flow shocks increases the risk of global portfolios and reduces investors' willingness to hold risky assets at all horizons. However, a similar upward shift in cross-country one-period return correlations resulting from correlated discount rate shocks has a much more muted effect on long-run portfolio risk and on the willingness to long horizon investors to hold risky assets. Correlated cash flow shocks imply that markets tend to move together at all horizons, thus reducing the scope for global diversification for all investors regardless of their investment horizon. By contrast, correlated discount rate shocks imply that markets tend to move together only transitorily and long-horizon investors can still benefit from global portfolios to diversify long-term cash flow risk. We document a secular increase in the cross-country correlations of stock and government bond returns since the late 1990's. We show that for global equities this increase has been driven primarily by increased cross-country correlations of discount rate shocks, or global capital markets integration, while for bonds it has been driven by both global capital markets integration and increased cross-country correlations of inflation shocks that determine the real cash flows of nominal government bonds. Therefore, despite the significant increase in the short-run correlation of global equity markets, the benefits from global equity portfolio diversification have not declined nearly as much for long-horizon investors as they have for short-horizon investors. By contrast, increased correlation of inflation across markets implies that the benefits of global bond portfolio diversification have declined for long-only bond investors at all horizons. However, it also means that the scope for hedging liabilities using global bonds has increased, benefiting investors with long-dated liabilities. Finally, we show that the well documented negative stock-bond correlation in the U.S. since the late 1990's is a global phenomenon, suggesting that the benefits of stock-bond diversification have increased in all developed markets.

JEL Classification: G12

Suggested Citation

Viceira, Luis M. and Wang, Zixuan (Kevin) and Zhou, John, Global Portfolio Diversification for Long-Horizon Investors (March 2017). Harvard Business School Finance Working Paper No. 17-085. Available at SSRN: https://ssrn.com/abstract=2941652

Luis M. Viceira (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6331 (Phone)
617-496-6592 (Fax)

HOME PAGE: http://www.people.hbs.edu/lviceira

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Zixuan (Kevin) Wang

Harvard Business School ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

John Zhou

Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

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