International Diversification: The Within- and Between-Region Effects

Abstract

We use a recently developed decomposition method to study the variance composition of 18 major national indices over the period 1974-2001. We find that over the sample period country-specific volatility has increased and, accordingly, the benefits of international diversification have remained substantial. We also find evidence in second moments of returns suggesting that international equity markets, as a whole, have not been more financially integrated over the sample. However, promoting economic integration is not without financial implications. By focusing on 10 European Union country indices, we find that the benefits of regional diversification within the EU have shrunk and the financial links among EU member states have been considerably strengthen over the sample period. All these imply that the between-region effects of international diversification have been growing over time, and international diversification is most effective when investors overcome their geographic proximity biases and invest in other regions.

Keywords: International diversification, Portfolio Choice

JEL Classification: G11, G15