How and why do individual U.S. investors diversify internationally? How significantly does this diversification affect their portfolio results? In their April 2007 paper entitled “Foreign Investments of U.S. Individual Investors: Causes and Consequences”, Warren Bailey, Alok Kumar and David Ng analyze the motivations and consequences of foreign equity investment by individual U.S. investors. Using personal characteristics and portfolio/trading data from tens of thousands of individual brokerage accounts at a major U.S. discount broker for the period 1/91-12/96, they conclude that:
- Across the entire sample, the mean monthly return for portfolios of internationally diversified individual investors is close to an appropriate U.S. stock market benchmark, but these investors achieve a significant reduction in mean portfolio volatility and a significant increase in mean portfolio Sharpe ratio. International diversification offers minimal benefit, however, to investors whose domestic holdings are well-diversified.
- Wealthy, experienced investors are more likely to diversify internationally. These sophisticated investors on average enhance risk-adjusted portfolio performance by significantly lowering return volatility and moderately increasing raw returns. Domestic diversification and conservatism (substantial dividend returns) also indicate a tendency to diversify internationally via foreign equity funds.
- Individuals with poor domestic portfolio performance seem to extend losing trading practices by sometimes diversifying into individual foreign stocks (rather than funds). These investors miss most of the benefits OF international diversification.
- Behaviorally-biased investors tend to underutilize or misuse international diversification and also miss most of the associated benefits. Specifically:
- Individuals who hold speculative stocks, use options or otherwise trade aggressively in their domestic portfolios tend to acquire speculative foreign equities, indicating more a desire to gamble than to diversify.
- Individuals who display behavioral tendencies such as local bias (domestic portfolios tilted towards geographically nearby companies), narrow framing (concentrating on the performances of individual holdings rather than on overall portfolio performance) and the disposition effect (selling winners too quickly and holding losers too long) are less likely to invest in foreign equities. When they do diversify internationally, they tend to acquire individual foreign stocks rather than foreign equity funds.
In summary, international diversification as implemented by individual U.S. investors on average neither compensates for bad investing/trading practices nor dramatically enhances good ones. While sophisticated investors generally improve returns and (especially) reduce portfolio volatility via positions in foreign equity funds, underperforming investors tend to underutilize or misuse foreign holdings.
