Sector Integration and the Benefits of Global Diversification

Abstract

One of the main reasons that investment advisors recommend international investments is that foreign stocks are not highly correlated with U.S. stocks. As world economies become increasingly interrelated, it may become more difficult for investors to achieve effective diversification. This research investigates international stock market correlation, and assesses whether global diversification on a sector basis is beneficial to U.S. investors. This analysis includes 38 developed and emerging stock markets from 1981-2000. In addition to demonstrating a potential loss of diversification benefits, this paper utilizes an optimal global asset allocation model to illustrate the effects of sector diversification on portfolio performance over time. The results indicate that although the correlation between most foreign sectors and U.S. sectors is increasing over time, there are still substantial international diversification benefits. Further, the inclusion of emerging market sectors may significantly enhance the return-to-risk performance of international portfolios (JEL: F21, F36, G11, G15)