Diversification: How much is enough?

Abstract

For years the virtues of international diversification have been widely espoused in the leading financial journals yet the focus has continued to remain on the benefits to a US based investor. There is an increased awareness in New Zealand surrounding both the importance and benefits accruing from international investment for a New Zealand based investor. Investment opportunities in New Zealand are reasonably limited because the small population base cannot support proliferation in a wide variety of industries. Accordingly investors are tempted to look for opportunities from offshore investments in an effort to enhance their portfolio by reducing risk reduction and increasing returns. The purpose of this research is to investigate the benefits accruing from international diversification to a New Zealand based investor in terms of total risk reduction. The focus of this study is on the effects of including additional foreign shares on the volatility of total portfolio return. Focusing only on risk allows the effect increased portfolio size has on portfolio risk to be determined in isolation from the effect on portfolio return. Consideration is given to the levels of portfolio risk obtainable in both the domestic and international settings. In addition we ask what countries produce benefits and determine the size of a portfolio that provides "significant" risk reduction for an investor.