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Measuring Gains from International Equity Diversification

The author uses a bootstrap replication to analyze the optimum allocation between U.S. and foreign equities. The bootstrap method enables a researcher to estimate the full distribution of portfolio returns. Research shows that international diversification increases risk-adjusted portfolio returns for two reasons. First, the return of the diversified portfolio is less variable, which by itself increases compound returns. Second, the reduced variability enables investors with given risk tolerances to allocate larger proportions of their overall portfolios to equities, thus increasing overall returns. To illustrate the benefits of international diversification, the author considers an increase in foreign equities from 0 to 40 percent of the equity portfolio. This change results in an increase of 65 basis points in risk-adjusted return.