REASONS FOR INCOMPLETE PORTFOLIO DIVERSIFICATION Many studies have demonstrated the gain from international diversifica-

REASONS FOR INCOMPLETE PORTFOLIO DIVERSIFICATION Many studies have demonstrated the gain from international diversifica-

tion. However, recent research has indicated that investors seem to greatly favor domestic assets and invest much less in foreign assets than one would expect given the expected gains from diversification. Tesar and Werner (1995) examined the foreign investment positions of major industrial countries for the 1970 1990 period, and found that international invest- ment as a fraction of the total domestic market for stocks and bonds equaled about 3 percent for the United States, 4 percent for Canada, 10 percent for Germany, 11 percent for Japan, and 32 percent for the United Kingdom. Calculations of an “optimal” investment portfolio would have much higher fractions devoted to international assets.

Recent studies have shown an increase in the international investment positions, but nowhere near the levels of an “optimal” investment portfolio. For example, Ferreira and Miguel (2011) show that the foreign bond position for the 1997 2009 period was slightly above 4 percent for the United States, 5 percent for Canada, 25 per- cent for Germany, 21 percent for Japan and 47 percent for the United Kingdom. In general, EMU countries had a high international

190 International Money and Finance

FAQ: How Internationally Diversified Is a U.S. Retirement Plan? U.S. pension plans are providing more opportunities for international

diversification. For example, TIAA-CREF, one of the largest pension providers in the U.S., started a global investment option in 1992. TIAA-CREF is a retirement fund used, in particular, by teachers and professors in the U.S. The global fund had $12 billion invested by September 2011. This is compared to the standard stock account that has $90 billion of invested funds.

The average annual return for the last 10-year period is 4.01% for the global fund and 4.47% for the U.S. stock fund. However, the risk is slightly lower with the global fund, with a 0.0382 variance of the standardized unit values, as compared to the U.S. stock portfolio that has a 0.0384 variance. The global fund and the U.S. stock fund are surprisingly similar both in return and risk. However, examining them closer, they are not as different as the name suggests. The U.S. stock portfolio has 69.6% U.S. stocks and the rest international ones. In comparison the global portfolio has 47.5% U.S. stocks. This is substantially less of an international portfolio diversification than the- ory would suggest. The home bias seems evident even in the “global” fund.

Why do investors seem to have this bias in favor of domestic securities? There are several possible reasons: taxes, transaction costs, or something else that is missing from the standard model of international investment. Let’s consider the alternatives in turn:

1. Taxes. If home bias is due to taxes, then the tax on foreign securities would have to be high enough to offset the higher return (or lower risk) expected from these securities. However, taxes paid to foreign governments can usually be credited against domestic taxes. Even if there is some net increase in the tax paid on foreign investment, it is unlikely that this increase could be high enough to discourage foreign investment to the extent observed.

2. Transaction costs. The cost associated with buying and selling foreign securities includes explicit monetary costs, like fees, commissions, and bid-ask spreads, and implicit costs such as differences in regulations protecting investors, language differences, and costs of obtaining infor-

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of the world for other goods and services, it is possible to imagine a situation where incomes fluctuate less than one might think based on fluctuations in domestic production. As output fluctuates for certain industries, relative prices change and this relative price change helps to smooth out income fluctuations. For instance, if the Philippines specializes in pineapple production and bad weather reduces the harvest, pineapple prices rise due to the reduction in supply. This price increase helps to cushion the fall in income related to the poor harvest. In this manner, relative price changes may serve as a natural hedge against output fluctuations, so that there is less income variabil- ity to be reduced through diversification. The puzzle of home bias has not been answered adequately. It may be

that there is no answer that can be related easily to financial models of investment. The surprisingly low level of international securities in investment portfolios may reflect investors’ decisions to hold undiversified portfolios, both internationally as well as domestically. Further research is needed to understand these issues better.

Although the investor risk considered so far has focused on the vari- ability of portfolio return, it should be realized that in international investment there is always the potential for political risk, which may involve the confiscation of foreigners’ assets. The next chapter will con- sider the analysis of such risk and includes a recent ranking of countries in terms of the perceived political risk attached to investments made in that country.