The International Diversification Puzzle is Worse than you Think
AbstractAlthough 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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Bibliographic InfoPaper provided by University of Rochester - Center for Economic Research (RCER) in its series RCER Working Papers with number 350.
Date of creation: 1993
Date of revision:
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Postal: University of Rochester, Center for Economic Research, Department of Economics, Harkness 231 Rochester, New York 14627 U.S.A.
Other versions of this item:
- Baxter, Marianne & Jermann, Urban J, 1997. "The International Diversification Puzzle Is Worse Than You Think," American Economic Review, American Economic Association, vol. 87(1), pages 170-80, March.
- Marianne Baxter & Urban J. Jermann, 1995. "The International Diversification Puzzle is Worse Than You Think," NBER Working Papers 5019, National Bureau of Economic Research, Inc.
- 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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- Mankiw, N.G. & Zeldes, S.P., 1990.
"The Consumption Of Stockholders And Non-Stockholders,"
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- N. Gregory Mankiw & Stephen P. Zeldes, 1991. "The Consumption of Stockholders and Non-Stockholders," NBER Working Papers 3402, National Bureau of Economic Research, Inc.
- Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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