An empirical regularity in the portfolio diversification literature is the importance of country effects in explaining international return variation. We develop a new decomposition that disaggregates these country effects into region effects and within-region country effects. We find that half the return variation typically attributed to country effects is actually due to region effects, a result robust across developed and emerging markets, with the remaining variation explained by within-region country effects. For the average investor, this means that diversifying across countries within Europe, for example, delivers half the risk reduction possible from diversifying across regions globally.
JEL classification: G11, G15
Keywords: diversification, risk, international financial markets, industrial structure
An earlier version of this paper was circulated as “International Stock Returns and Market Integration: A Regional Perspective.” We are grateful to Geert Rouwenhorst for extensive comments and suggestions and to Eisuke Okada 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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