Investor Diversification and International Equity Markets

Investors in every major market hold almost all of their equity wealth at home, even though returns across national markets are far from perfectly correlated – the average pairwise correlation between quarterly real returns on the US, Japanese, UK, French, German and Canadian markets over 1975-89 is 0.502, which the authors say “suggests that nontrivial risk reduction is available from cross-border holdings.” This paper measures how large a belief it takes to sustain that concentration. Using estimated portfolio weights for December 1989 – Japanese investors held only 1.9 percent of their equity in foreign stocks, US investors 6.2 percent, and British investors 18 percent, the last split roughly evenly among the United States, continental Europe and Japan – the authors take the covariance matrix of returns as estimable, assume a representative investor in each country with the utility function printed as U(W) = -exp(-AW/W0) and A = 3 holding only the equity of the six largest markets, and invert the first-order condition for optimal weights to recover the expected returns that would make the observed holdings optimal. Against a benchmark of equal expected returns everywhere, the implied home-market premia are large: British investors must expect UK returns more than 500 basis points a year above US returns to justify holding 82 percent domestically, a differential the authors attribute to the substantially higher standard deviation of British returns; US investors must expect US stocks to beat Japanese stocks by 250 basis points; Japanese investors must expect the reverse ranking by 350 basis points. The same numbers imply that investors of different nationalities disagree sharply about the same market, with Japanese investors expecting more than 300 basis points more from Japanese stocks than US investors do. The authors are careful that equal expected returns “may not be an appropriate benchmark,” so they recompute the deviation against an international value-weighted strategy: on that comparison US investors need only about 90 basis points of home-market optimism and about 110 basis points of pessimism about Japan, while Japanese investors still need 250 basis points and British investors over 400. They then argue institutional explanations do not fit – tax burdens on foreign and domestic equity income are similar for most investors once withholding taxes are credited at home (worth only about 50 basis points even for tax-exempt investors who cannot claim the credit), transaction costs should push everyone toward the most liquid market rather than toward their own, and the identified legal limits are not binding, as shown by foreigners being substantial net sellers of Japanese shares in the mid-1980s and of US equities in 1988. Their conclusion is stated as an inference about where the explanation must lie rather than a demonstration of a specific mechanism: incomplete diversification “is the result of investor choices,” with systematically differing return expectations (documented directly in a 1990 survey of Japanese and US portfolio managers) and familiarity-driven perceptions of risk the leading candidates – and they add that the level of cross-border investment, though low, “is growing and with time the international diversification puzzle may recede.”

James M. Poterba | Macro Paper Warehouse

Investor Diversification and International Equity Markets