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Investment and Portfolio
Management
Empirical Evidence on Diversification
Objectives
• Do investors diversify?
• Is it easy for emerging market investors to diversify using local
equities?
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Diversification
Do Investors Diversify?
Extent of Diversification by Investors
• Our previous discussion (and examples) has shown that a
substantial reduction in risk can be achieved by creating a
portfolio with appropriate assets. This process of risk reduction
via creation of portfolio is called diversification.
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Extent of Diversification by Investors
• Benefits of diversification increase many folds when we include
assets from countries with business cycles that are not highly
correlated with home country business cycle. Such diversification
reduces the portfolio’s responsiveness to market movements.
• Over long periods, internationally diversified portfolios tend to
perform better (meaning that they earn higher returns relative to
the risks taken) than purely domestic portfolios.
Extent of Diversification by Investors
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Extent of Diversification by Investors
• However, despite the gains from cross-border diversification,
investors tend to prefer domestic securities. This preference for
domestic securities is called the home bias.
Extent of Diversification by Investors
• Next figures show that empirical evidence regarding the extent of
home bias (from the perspective of the U.S. investor).
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Extent of Diversification by Investors
Extent of Diversification by Investors
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Extent of Diversification by Investors
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Extent of Diversification by Investors
• Plausible explanations for investor’s preference for domestic
equities include:
• Existence of cross-border boundaries (that give rise to exchange rate risk,
variation in regulation, culture, taxation, accounting standards, corporate
governance, language, and economic and market development)
• Information asymmetries
• Non-information related factors (familiarity or recognition bias)
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Extent of Diversification by Investors
• Research also shows that the home-bias phenomenon exists even
at home. Coval and Moskowitz (1999), for example, find that U.S.
professional money managers exhibit a strong bias toward locally
headquartered firms in their domestic stock portfolios.
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Diversification
Diversification in Emerging Markets
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Diversification in Emerging Markets
• Another important question worth asking is: How easy is it to
create diversified portfolio within an emerging market?
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Diversification in Emerging Markets
• Morck et al. (2000) show that stock prices in emerging markets
tend to move up or down together. This is in sharp contrast with
stock prices in developed markets that tend to move in
unsynchronized way.
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Diversification in Emerging Markets
• When stock prices move up or down together, it means that there
is lesser amount of firm-level information in stock prices and the
prices are reacting more to industry-level or market-level
information.
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Diversification in Emerging Markets
• However, as the markets become more mature, firm-level
information increase, and stock price movements become less
synchronous.
• A time series of stock price synchronicity for the U.S. market also
shows that the degree of co-movement in U.S. stock prices has
declined, more or less steadily, during the 20th century.
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Diversification in Emerging Markets
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Diversification in Emerging Markets
• Next table compares the synchronicity of stock returns in some
representative stock markets during the first 26 weeks of 1995.
• In emerging markets like China, Malaysia, and Poland, over 80% of
stocks often move in the same direction in a given week. In Poland,
100% of traded stocks move in the same direction during four of
the twenty six weeks.
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Diversification in Emerging Markets
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Diversification in Emerging Markets
• In contrast to emerging markets, Denmark, Ireland, and the United
States lack any instances of more than 57% of the stocks moving in
the same direction during any week.
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Diversification in Emerging Markets
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Diversification in Emerging Markets
• Next figure contrasts Chinese, Malaysian and Polish stocks with
U.S. stocks.
• The result shows excessive synchronous patterns for emerging
markets.
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Diversification in Emerging Markets
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Diversification in Emerging Markets
• There can be a number of plausible explanations for these
observations. Some of them are as follows:
• Firms in emerging markets might have more correlated fundamentals,
and this correlation might make their stock prices move more
synchronously.
• Emerging markets often provide poor and uncertain protection of private
property rights. Political events and rumors in such countries could, by
themselves, cause market-wide stock price swings.
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Diversification in Emerging Markets
• Inadequate protection for property rights could cause reduction in
informed trading in these stock markets unattractive. According to De
Long et al. (1989, 1990), a reduction in informed trading can increase
market-wide noise, which we would observe as increased market-wide
stock price variation unrelated to fundamentals.
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Diversification in Emerging Markets
• In countries that provide poorer protection for public investors from
corporate insiders, problems such as inter-corporate income shifting
could make firm-specific information less useful, and therefore impede
the capitalization of firm-specific information into stock prices. This effect
would reduce firm-specific stock price variation, again increasing stock
return synchronicity.
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Diversification in Emerging Markets
• In another related study, Farooq et al. (2018) show excessive co-
movement in stock prices in the MENA region. They report that co-
movement in stock prices leads to higher volatility in the MENA
regions. They also document that vast amount of stock market
volatility can be explained by co-movement in stock prices.
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Diversification in Emerging Markets
• Figures in the subsequent slides show fraction of stocks going up
in a given week in the MENA region.
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Diversification in Emerging Markets
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Diversification in Emerging Markets
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Diversification in Emerging Markets
• Figures in the subsequent slides show fraction of stocks going
down in a given week in the MENA region.
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Diversification in Emerging Markets
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Diversification in Emerging Markets
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Diversification
References
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References
• Coval, J.D. and Moskowitz, T.J., (1999). Home Bias at Home: Local
Equity Preference in Domestic Portfolios. Journal of Finance, 54,
pp. 2045-2073.
• Farooq, O., Bouaddi, M., and Ahmed, N., (2018). Stock Price
Synchronicity and its Effect on Stock Market Volatility: Evidence
from the MENA Region. Forthcoming, American Journal of Finance
and Accounting.
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References
• Morck, R., Yeung, B. and Yu, W., (2000). The Information Content of
Stock Markets: Why do Emerging Markets have Synchronous Stock
Price Movements? Journal of Financial Economics, 58(1-2), pp.
215-260.
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