portfolio diversification analysis

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a. Analyze the effects of international portfolio diversification on an investment portfolio

The idea behind international diversification is that by adding non-U.S. assets to a U.S. portfolio, investors reduce portfolio-level volatility and, thereby, generate better risk-adjusted returns. In any given period, portfolio returns in international markets may be higher or lower than returns generated in an investor's domestic market. However, over long holding periods (including the poor performance of the recent decade) international diversification has delivered on the promise of reducing portfolio volatility and enhancing risk-adjusted returns.

Over the past 30 years, portfolios comprising both U.S. and non-U.S. equities have experienced higher returns and lower levels of overall risk. Risk reduction was the dominant effect for those who invested internationally during the past decade.

While the realized correlation of returns between US equities and non-US equities has risen in recent years, there is little evidence that changes in underlying cashflows have become more correlated across countries. While the changes in valuation ratios across countries have become more correlated, we question the extent to which elevated 'valuation correlation' can persist in the face of fundamental cashflow growth diversification. Although we are hesitant to endorse international equities from a relative return standpoint, we believe that capitalization, realized return and valuation data suggest that international equities are at least as attractive as US equities - if not more so.

Source: http://www.ssga.com/library/resh/ericbrandhortsinternationaldiversification71502/page.html

Another good reference:

http://www.tcd.ie/iiis/documents/discussion/pdfs/iiisdp167.pdf.

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