International diversification - Essay Example

International diversification International diversification has been found to be very beneficial for portfolio investment. There are several ways by which international diversification especially the countries favourable for investment growth is preferable over domestic diversification. Jean-Claude and Jean-Marc propound that “global diversification allows for reduced total risk without sacrificing expected returns.” (1995, p301) International diversification disperses the investment risk to a number of shares and securities in a given portfolio and thus leads to minimisation of risk with maximum rate of return. For example, if an investor purchases some shares in his home country i.e. and also includes in his portfolio a number of shares from international countries like the United States and European countries, the risk associated with both the investments i.e. domestic and international diversification would be different based upon the various political, economic and investment factors. Thus depending upon the condition of stock markets in every single country in the portfolio, the risk will be diversified ensuring a high rate of return on investment. Fig 1: Stock Market Statistics S&P500 DAX WIG Mean 7.010 8.465 9.656 Median 7.018 8.518 9.646 Std. Deviation 0.186 0.287 0.139 Skewness -0.152 -0.330 0.218 See: Syriopoulos (2004, p1261) Fig 1 shows the comparative statistics of stock market indexes of three countries i.e. the United States and the two European countries i.e. Germany and Poland. If we suppose that an investor from UK diversifies his portfolio of investments in the stock market of these three international countries. The differences in the statistics shown in the Fig1 propose that the level of risk and return would certainly vary from country to country that will ensure maximum returns for investors. International portfolio diversification is highly beneficial in a situation where the stock exchanges, economic condition and political environment of international countries are highly different from each other. Syriopoulos also says that “if returns from investments in different national stock markets are not perfectly correlated and the correlation structure is stable, there are potential gains from international portfolio diversification.” (2004, p1254) It is so because the diversification would not yield the desired results if the conditions and environment in international countries vary in the same manner as in domestic economy. If the international countries included in the portfolio have an economic, political and investment environment that differs from that of the domestic environs, the international portfolio diversification will reap significant benefits. Question 2: The Capital Asset Pricing Model is an effective tool for portfolio management. Because of the model’s efficiency in pricing assets, it is considered to be useful in evaluating risk and return on various assets in a given portfolio. The most significant usefulness of the CAPM in portfolio analysis is its effectiveness in illuminating the risk factor involved in a portfolio investment. Andre explores that “the CAPM tells us that investors pay a price for being undiversified in that they are taking risks for which they are not being compensated.” (2004, p19) For un-diversifiable or systematic risk, this model uses Beta as a means to identify the rate of risk involved in investment. CAPM can thus be useful for investors in portfolio management by providing relevant information concerning the risk factor involved in a particular investment with respect to the whole market and also lead the investors to improve their portfolio. With the help of the Capital Asset Pricing Model, the investors can easily determine the required rate of return with respect to different assets in the portfolio according to their risk without any efforts to estimate revenues and cash flows. Andre illuminates that in order “to find the expected return of a company's shares, it is thus not necessary to carry out an extensive financial analysis of the company and to forecast its future cash flows.” (2004, p17) This model is also effective in the sense that it requires only investment relevant information for the purpose of determining the rate of return on investment rather than future estimation. Apart from the above mentioned benefits, there happen to be significant drawbacks of using CAPM for the purpose of portfolio management. The problem with this model is that it relies on beta to gauge the risk on a given investment. Andre puts forward that “it is true that a high beta stock will tend to have a high stand-alone risk because a portion of a stock's stand-alone risk is determined by its beta, but a stock need not have a high beta to have a high stand-alone risk.” (2004, p17) This suggests that having a high or low beta does not encompass all the relevant risks in any asset. Furthermore, if beta is low, it cannot be exactly said that there happens to be low risk associated with the investment. If beta of any asset in a given portfolio is significantly high, investors expect a higher return on such investments. However, the point that is worth noting is that there happens to be less return on high beta assets if the premium is negative ex-post (see Chi-Hsiou, Shackleton and Xu, 2004). Pastor (2000) elaborates that domestic and international portfolio management using CAPM is influenced greatly by investor’s confidence in the domestic CAPM. Utilisation of CAPM in portfolio management can thus become in effective if the investors beliefs are falsely biased towards home country. If investor is more biased towards the domestic investment and is also including international assets in the portfolio the measurement of risk and management of the portfolio would become difficult. However these drawbacks are worth consideration, but an evaluation of the Capital Asset Pricing Model as a whole suggests that it is an extremely useful approach towards portfolio management. Question 3: The Efficient Market Hypothesis states that information is reflected well in stock prices as well as the stock market. The impact of information on stock price is highly immediate and there can be no way though which the investors can obtain abnormal equity returns. Malkiel (2003) suggests that equity returns may vary from size, value and risk of various stocks. Also, the tendency of stock prices to under or over react to news and information about certain events could also make the investors to exploit the situation to extract more gains. Similarly, there are events or seasons in which over-reaction to information takes place or investors are able to expect abnormal gains out of equity investment (Chari, Jagannathan and Ofer 1988). This under and over-reaction of stock price and market to information seems to be invalidating the Efficient Market Hypothesis. The tendency of certain stocks such as share price of small companies to under or over react to certain information and events is likely to increase occasional pressures in the market and the proposition that abnormal equity returns are not attainable does not hold good. An efficient market operates on the basis that information puts a great impact on prices. The response to information can be either under-reaction or over-reaction. Abnormal equity returns can be generated in some specific cases like negative long-term abnormal returns in mergers for acquiring firms, positive abnormal returns in the post stock splits event, negative abnormal returns in the case of listing in new stock exchange, positive abnormal returns for companies paying dividends for the first time and negative abnormal returns for the ones that suddenly stop paying dividends. However most of these discrepancies are less significant or marginal in affecting returns on a large scale (Fama, 1998). These predictable events lead to trading or investing strategies on the part of investors so as to achieve high abnormal returns (Jegadeesh and Titman, 1993). The predictability of these events on the part of investors can enhance the chances of abnormal returns even in efficient market scenario. However the effects of these events and seasonal predictions might be minimal and temporary, yet they are potent enough to increase expectation of abnormally high return on investment because in such situations investors become inclined to gain advantage of market expectations. Bibliography Andre F.P. (2004), The Capital Asset Pricing Model, Journal of Economic Perspectives, 18(3), Summer, 3-24 Chari, V.V., Jagannathan R., and Ofer A. (1988), Seasonalities in Security Returns: The Case of Earnings Announcements, Journal of Financial Economics, 21, 101-121 Chi-Hsiou H.D., Shackleton, M. And Xu, X. (2004), CAPM, Higher Co-moment and Factor Models of UK Stock Returns, Journal of Business Finance & Accounting, 31(1) & (2), January/March, 87-112 Fama, E.F. (1998), Market efficiency, long-term returns, and behavioural finance, Journal of Financial Economics, 49, 283-306 Jean-Claude, C. and Jean-Marc, S. (1995) Political risk and the benefits of international portfolio diversification, Journal of International Business Studies, 26(2), 301-318 Jegadeesh, N. and Titman, S. (1993), Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, The Journal of Finance, 48(1), March, 65-91 Malkiel, B.G. (2003), The Efficient Market Hypothesis and Its Critics, Journal of Economic Perspectives, 17(1), winter, 59-82 Pastor, L. (2000), Portfolio Selection and Asset Pricing Models, The Journal of Finance, 55(1), February, 179-223 Syriopoulos, T. (2004) International portfolio diversification to Central European stock markets, Applied Financial Economics, 14, 1253–1268 Read More