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The International Diversification Puzzle is Worse than you Think

Author

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  • Baxter, M.
  • Jermann, U.J.

Abstract

Although international financial markets are highly integrated across the more well-developed countries, investors nevertheless hold portfolios that consist nearly exclusively of domestic assets. This violation of the predictions of standard theories of portfolio choice is known as the 'international diversification puzzle.' In this paper, we show that the presence of nontraded risk associated with variations in the return to human capital has dramatic implications for the optimal fraction of domestic assets in an individual's portfolio. Our analysis suggests that the returns to human capital are highly correlated with the returns to domestic financial assets. Hedging the risk associated with nontraded human capital involves a short position in national equities in an amount approximately 1.5 times the value of the national stock market. Thus optimal and value- weighted portfolios very likely involve a short position in domestic marketable assets.
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Suggested Citation

  • Baxter, M. & Jermann, U.J., 1993. "The International Diversification Puzzle is Worse than you Think," RCER Working Papers 350, University of Rochester - Center for Economic Research (RCER).
    • Handle: RePEc:roc:rocher:350
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    Keywords

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    JEL classification:

    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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