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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
5019.
Length: Date of creation: Feb 1995 Date of revision: Publication status: published as american economic review, march 1997. Handle: RePEc:nbr:nberwo:5019
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Find related papers by 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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