The Investor's Perspective: Portfolio Diversification
By using the global capital market, investors have a much wider range of investment opportunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to below what could be achieved in a purely domestic capital market. We will consider how this works in the case of stock holdings, although the same argument could be made for bond holdings.
Consider an investor who buys stock in a biotech firm that has not yet produced a new product. Imagine the price of the stock is very volatile--investors are buying and selling the stock in large numbers in response to information about the firm's prospects. Such stocks are risky investments; investors may win big if the firm produces a marketable product, but investors may also lose all their money if the firm fails to come up with a product that sells. Investors can guard against the risk associated with holding this stock by buying other firms' stocks, particularly those weakly or negatively correlated with the biotech stock. By holding a variety of stocks in a diversified portfolio, the losses incurred when some stocks fail to live up to their promises are offset by the gains enjoyed when other stocks exceed their promise.
As an investor increases the number of stocks in her portfolio, the portfolio's risk declines. At first this decline is rapid. Soon, however, the rate of decline falls off and asymptotically approaches the systematic risk of the market. Systematic risk refers to movements in a stock portfolio's value that are attributable to macroeconomic forces affecting all firms in an economy, rather than factors specific to an individual firm. The systematic risk is the level of nondiversifiable risk in an economy. Figure 11.3a illustrates this relationship for the United States. It suggests that a fully diversified US portfolio is only about 27 percent as risky as a typical individual stock.
By diversifying a portfolio internationally, an investor can reduce the level of risk even further because the movements of stock market prices across countries are not perfectly correlated. For example, one recent study looked at the correlation between three stock market indexes. The Standard & Poor's 500 (S&P 500) summarized the movement of large US stocks. The Morgan Stanley Capital International Europe, Australia, and Far East Index (EAFE) summarized stock market movements in other developed nations. The third index, the International Finance Corporation Global Emerging Markets Index (IFC) summarized stock market movements in less developed "emerging economies." From 1981 to 1994, the correlation between the S&P 500 and EAFE indexes was 0.45, suggesting they moved together only about 20 percent of the time (i.e., 0.45 * 0.45 = 0.2025). The correlation between the S&P 500 and IFC indexes was even lower at 0.32, suggesting they moved together only a little over 10 percent of the time.5
The relatively low correlation between the movement of stock markets in different countries reflects two basic factors. First, countries pursue different macroeconomic policies and face different economic conditions, so their stock markets respond to different forces and can move in different ways. For example, in 1997, the stock markets of several Asian countries, including South Korea, Malaysia, Indonesia, and Thailand, lost over 50 percent of their value in response to the Asian financial crisis, while at the same time the S&P 500 increased in value by over 20 percent. Second, different stock markets are still somewhat segmented from each other by capital controls--that is, by restrictions on cross-border capital flows (although such restrictions are declining rapidly). The most common restrictions include limits on the amount of a firm's stock that a foreigner can own and limits on the ability of a country's citizens to invest their money outside that country. For example, until recently it was difficult for foreigners to own more than 30 percent of the equity of South Korean enterprises. Tight restrictions on capital flows make it very hard for Chinese citizens to take money out of their country and invest it in foreign assets. Such barriers to cross-border capital flows limit the ability of capital to roam the world freely in search of the highest risk-adjusted return. Consequently, at any one time, there may be too much capital invested in some markets and too little in others. This will tend to produce differences in rates of return across stock markets.6 The implication is that by diversifying a portfolio to include foreign stocks, an investor can reduce the level of risk below that incurred by holding just domestic stocks.
Figure 11.3b illustrates the relationship between international diversification and risk found by a now classic study.7 According to the figure, a fully diversified portfolio that contains stocks from many countries is less than half as risky as a fully diversified portfolio that contains only US stocks. A fully diversified portfolio of international stocks is only about 12 percent as risky as a typical individual stock, whereas a fully
Figure 11.3 see
Risk Reduction through Portfolio Diversification
Source: B. Solnik, "Why Not Diversify Internationally Rather than Domestically?" Adapted with permission from Financial Analysts Journal, July/August 1974, p. 17, Copyright 1974, Financial Analysts Federation. Charlottesville, VA. All rights reserved.
diversified portfolio of US stocks is about 27 percent as risky as a typical individual stock. More recent studies have tended to confirm the relationship summarized in Figure 11.3b. A 1994 study of portfolio diversification in Europe found that a diversified portfolio of stocks held within a single country was on average about 38 percent as risky as a typical individual stock, whereas a portfolio of stocks that was diversified across 12 European countries was only 18 percent as risky as a typical individual stock.8 Such data suggest a strong case for investing internationally as a means of diversifying risk.
The risk-reducing effects of international portfolio diversification would be greater were it not for the volatile exchange rates associated with the current floating exchange rate regime. Floating exchange rates introduce an additional element of risk into investing in foreign assets. As we have said repeatedly, adverse exchange rate movements can transform otherwise profitable investments into unprofitable investments. The uncertainty engendered by volatile exchange rates may be acting as a brake on the otherwise rapid growth of the international capital market.
Figure 11.4
Net International Bank Lending ($ billions)
Source: Bank for International Settlements database.
Growth of the Global Capital Market
In the introduction, we noted that there has been rapid growth in the size of the global capital market in recent years. The following figures add some substance to this claim.9 Figure 11.4 shows the growth in international bank lending from 1983 to the end of 1997. As can be seen, international bank lending increased rapidly over this period, hitting a record $5.3 trillion by the end of 1997. Figure 11.5 shows the quarter-by-quarter increase in international bond issuance, from 1994 through 1997. By 1997, international bond issues were running at over $250 billion per quarter, up from $110 to $150 billion a quarter in 1994. Figure 11.5 also gives details of the currency in which most international bonds were issued. The US dollar has been the favored currency for issuing international bonds. Figure 11.6 shows the volume of international equity offerings between 1985 and 1997. Again, there has been a steep increase, with international equity issues closing in on $100 billion in 1997, up from about $4 billion in 1985. Figure 11.6 also shows details of the Morgan Stanley Capital Market International World Stock Market Index. As can be seen, the value of world stock markets has also increased substantially. It is easier to raise capital from new stock issue in a climate where stock markets are rising than in one where stock markets are declining in value. A decline in the value of world stock markets, such as occurred toward the end of 1987, makes it more difficult for companies to raise additional funds from international equity issues.
The data contained in Figures 11.4 to 11.6 clearly illustrate the rapid growth in the size of the global capital market in recent years. What factors allowed the international capital market to bloom in the 1980s and 1990s? There seem to be two answers--advances in information technology and deregulation by governments.