Are the gains from international portfolio diversification exaggerated? The influence of downside risk in bear markets

Are the gains from international portfolio diversification exaggerated? The influence of downside risk in bear markets

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,...

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Bibliographic Details
Published in:Journal of international money and finance Vol. 21; no. 7; pp. 981 - 1011
Main Authors: Butler, K.C, Joaquin, D.C
Format: Journal Article
Language:English
Published: Kidlington Elsevier Ltd 01-12-2002
Elsevier
Elsevier Science Ltd
Series:Journal of International Money and Finance
Subjects:
Bear markets
Bull markets
Correlation
Correlation analysis
Diversification
Downside risk
Financial markets
GARCH
Normal
Portfolio diversification
Portfolio investments
Risk
RiskMetrics
Student- t
Studies
Student- t
Correlation
Financial markets
C34
G11
C15
G15
Bear markets
Normal
Portfolio diversification
RiskMetrics
Downside risk
GARCH
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Summary: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 yield 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 US 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.
ISSN:0261-5606
1873-0639
DOI:10.1016/S0261-5606(02)00048-7