Investment Enhancement Paper

Investment Enhancement Paper

Effects of International Portfolio Diversification

In the world today, investors are well aware of the fact that the equity market is highly volatile which means very risky. Traditionally, Americans used to invest in local equity markets to gain to capitalize on return. It was later realized that local, country risk is an issue and needs to be evaluated. Country risk indicates that there exists a risk where investments put in a certain nation undergo an attack due to some problem faced in the country. Those problems reflect the modifications in the business environment and can affect negatively the profits or valuation of assets in that country. This is better explained with an example. If an investor invests in Greece right now, there is a high (risky) chance of losing your investment and making a loss. Greece is in high debt and is facing financial problems.

This sort of problem (country risk) led to the development of international portfolio diversification. As the market has evolved and globalization occurred, international boundaries were open for trading. This allowed investors to expand their horizons and invest in other markets. A past indication exhibits the advantage of international diversification. In the year 2006, American indices had double-digit premiums. However, the part that investors didn't realize is that if they had invested in countries outside the United States of America, they would have received higher returns. A study by Yavas (2007) illustrates that as compared to the 12.6% gained from stock market funds in the USA, the international stock funds generated a 25.5%, double the American investment potential. After this predicament, U.S. based brokers started recommending to their clients to create portfolios consisting of foreign equities (Yavas, 2007).

The first benefit of international portfolio diversification is justified by the Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT). Both theories suggest that an investor needs to hold a diversified portfolio in order to minimize risk for maximum return. By investing not only in local markets but also in foreign markets, the risk in one country can be covered by the risk in another country. The second benefit is that different countries have distinctive periods of economic growth and various periods of business cycles. If somebody is investing in the Shanghai stock exchange, the London Stock Exchange, and the New York Stock Exchange, there is a reduction in risk due to the fact all three markets cannot simultaneously crash or be in loss at the same time (Fisher 2012).

The con against international diversification is the fact that several markets are becoming interdependent. This means that if one is having problems and is falling, the other markets eventually also follow. This can be seen during the event of 9/11 where the US stock market, the German stock market, and the Japanese stock market formed correlated relationships and declined. The other con is the currency risk which evaluates markets higher or lower in terms of returns.

Alternative Investment Vehicles

In the current year, investors have shifted their focus ...