Global Portfolio Diversification for Long-Horizon Investors

72 Pages Posted: 27 Mar 2017 Last revised: 17 May 2018

Luis M. Viceira

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

Zixuan (Kevin) Wang

Harvard Business School

Date Written: May 1, 2018

Abstract

This paper conducts a theoretical and empirical investigation of the risk 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. An increase in the cross-country correlations of cash flow shocks raises the risk of a globally diversified portfolio at all horizons. By contrast, an increase in the cross-country correlations of discount rate shocks has a much more muted effect on portfolio risk at long horizons, suggesting that the benefits of global portfolio diversification to long-term investors do not recede when the source of increased global return correlations is correlated discount rates. Empirically, we document a secular increase in the cross-country correlations of both stock returns and government bond returns since the late 1990’s. We identify increased correlations of discount rate shocks resulting from financial globalization as the main driver of the upward shift in stock return correlations. We also identify increased correlations of inflation shocks as an equally important source of the upward shift in bond correlations. By contrast, we don’t find evidence of a secular shift in the cross-country correlations of stock market volatility shocks, which have remained fairly low through time except during the financial crisis of 2009.

JEL Classification: G12

Suggested Citation

Viceira, Luis M. and Wang, Zixuan (Kevin), Global Portfolio Diversification for Long-Horizon Investors (May 1, 2018). Harvard Business School Finance Working Paper No. 17-085. Available at SSRN: https://ssrn.com/abstract=2941652 or http://dx.doi.org/10.2139/ssrn.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

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