ABSTRACT
As we explained in Chapter 1, the world as a whole benefits from international investment via a better allocation of financial capital, and a smoother wealth or consumptive stream from lending and borrowing. Individual investors gain in these same ways from engaging in international investment and thereby achieving a more efficient portfolio. Stated in the vernacular of finance, diversified international investment offers investors higher expected returns and/or reduced risks vis-à-vis exclusively domestic investment.This chapter focuses on the sources and sizes of these gains from venturing overseas for portfolio investment, which is investment in equities and bonds where the investor’s holding is too small to provide any effective control. (Direct investment, defined in Chapter 7 as investment where the investor achieves some control – via 10 percent or more ownership – is discussed separately in Chapters 19 and 20.)
Because of risk aversion, investors demand higher expected returns for taking on investments with greater risk. It is a well-established proposition in portfolio theory that whenever there is imperfect
correlation between different assets’ returns, risk is reduced by maintaining only a portion of wealth in any individual asset. More generally, by selecting a portfolio according to expected returns, variances of returns, and correlations between returns, an investor can achieve minimum risk for a given expected portfolio return, or maximum expected portfolio return for a given risk. Furthermore, ceteris paribus, the lower are the correlations between returns on different assets, the greater are the benefits of portfolio diversification.
