A stylized fact in the portfolio diversification literature is that diversifying across countries is more effective than diversifying across industries in terms of risk reduction. But with the rise in comovement across national stock markets since the mid-1990s, this no longer appears to be true. We explore whether this change is driven by global integration and therefore likely to be permanent, or if it is a temporary phenomenon associated with the recent stock market bubble. Our results point to the latter hypothesis. In the aftermath of the bubble, diversifying across countries may therefore still be effective in reducing portfolio risk.
JEL classification: G11, G15
Keywords: diversification, risk, international financial markets, industrial structure
An earlier version of this paper circulated under the title “Country versus Industry Factors in Global Stock Returns.” The authors thank Stefano Cavaglia, John Griffin, Mark Kamstra, and Andrew Karolyi for helpful conversations, Ashoka Mody and Geert Rouwenhorst for extensive comments on earlier drafts, and Young Kim for excellent research assistance. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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