International Portfolio Investment

The world as a whole benefits from international investment via a better allocation of financial capital, and a smoother wealth or consumptive stream from lending and borrowing.  Individual investors gain in these same ways from engaging in international investment and thereby achieving a more efficient portfolio.  Because of risk aversion, investors demand higher expected return for taking on investments with greater risk.  It is well-established proposition in portfolio theory that whenever there is imperfect correlation between different assets’ returns, risk is reduced by maintaining only a portion of wealth in any individual asset.  More generally, by selecting a portfolio according to expected returns, variances of returns, and correlation between returns, an investor can achieve minimum risk for a given expected portfolio return, or maximum expected return for a given risk.  Furthermore, the lower are the correlations between returns on different assets, the greater are the benefits of portfolio diversification.

Within an economy there is some degree of independence of asset returns, and this provides some diversification opportunities for investors who do not venture abroad.  However, there is a tendency for the various segments of an economy to feel jointly the influence of overall domestic activity, and for asset returns to respond jointly to prospects for domestic activity, and uncertainties about these prospects.  This limits the independence of individual security returns, and therefore also limits the gains to be made from diversification within only one country.  Because of different industrial structures in different countries, and because different economies do not trace out exactly the same business cycles, there are reasons for smaller correlation of expected returns between investments in different countries than between investments within any one country.  This means that foreign investments offer diversification benefits that cannot be enjoyed by investing only at home and means, for example, that a US investor might include British stocks in a portfolio even if they offer lower expected returns than US stocks: the benefits of risk reduction might more than compensate for lower expected returns.