Slide MGT411 Slide14

Chapter 17
International Portfolio
Theory and
Diversification

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

International Diversification
and Risk
•

The case for international diversification of portfolios can be
decomposed into two components, the first of which is the potential
risk reduction benefits of holding international securities.

•

This initial focus is on risk.

•

The risk of a portfolio is measured by the ratio of the variance of a
portfolio’s return relative to the variance of the market return
(portfolio beta).

•

As an investor increases the number of securities in a portfolio, the
portfolio’s risk declines rapidly at first, then asymptotically
approaches the level of systematic risk of the market.

•

A domestic portfolio that is fully diversified would have a beta of 1.0.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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Exhibit 15.1 Portfolio Risk
Reduction Through

PercentDiversification
risk = Variance of portfolio return
Variance of market return

100
80
Total Risk
60

=

Diversifiable Risk
(unsystematic)

40

+

Market Risk
(systematic)

Portfolio of
U.S. stocks

27%

Total
risk

20

1

Systematic
risk
10

20
30
40

Number of stocks in portfolio

50

By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the market’s
return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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