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The International Diversification Puzzle is Worse Than You Think

Marianne Baxter () and Urban Jermann ()

No 5019, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Although 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.

JEL-codes: F40 G11 (search for similar items in EconPapers)
Date: 1995-02
Note: IFM
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Published as American Economic Review, march 1997.

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Working Paper: The International Diversification Puzzle is Worse than you Think (1993)
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