International Diversification

Introduction

Diversification is a method of investing that been shown to increase portfolio return while reducing portfolio risk as measured by standard deviation. This method specifically increases the efficient frontier for investors. The challenge to an investing firm is an appetite by its customers for an ever increasing efficient frontier. One area to explore to obtain this increase is through further diversifying through international diversification. International portfolio diversification gives your investments a passport to added diversification benefits.

The international boundaries to investing have collapsed. Fairly recently, foreign securities have become easier to trade due to improved communications and data technology. Worldwide investors have been realizing that there are substantial gains to be made by investing internationally. International portfolio diversification is portfolio investing in other nations whose economic cycles are not perfectly in phase, in an attempt to reduce risk, measured by portfolio standard deviation. The success of international portfolio diversification depends on low correlations of returns between countries.

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Investing in a country with an economic cycle that closely matches or exactly matches the economic cycle in the investor’s home country will offer little or no diversification benefits. What is meant by a diversification benefit is a reduction of portfolio risk when an asset is added to a portfolio. The same principles that go along with domestic portfolio diversification can be applied worldwide. Opening the gates of an investor’s portfolio to the world offers the investor several advantages. The benefits include: a world focus; broad diversification; and low correlations.

These advantages will lead the investor to have greater success in achieving his financial goals. By investing internationally, an investor will realize that he now has a world focus. More than half of the world’s stock market capitalization is in non-US companies. By only having a domestic focus, an investor loses sight of the investment opportunities that can be realized overseas. International investment also brings a broader range of investments for diversification. By increasing the number of assets available to invest in, international diversification can lessen risks and produce more stable returns.

New assets available to invest in could range from a foreign company’s stock to a foreign country’s currency. The potential for a diversification benefit exists in all foreign investments. This potential should not be ignored. {draw:frame} The potential is even greater due to the low correlations that can be found internationally. Returns from different national markets have relatively lower correlation than the domestic market. The lower these correlations are, the greater the diversification benefit will be. The reason that international diversification is beneficial is that individual markets have unsystematic risk.

This unsystematic risk can be diversified away by adding international assets. This risk is due to risk that results from uncontrollable or random events that are country specific. According to Solnik, 1974, internationally diversified portfolios can have as little as 11. 7% of the risk of individual securities. The underlying reason for added risk reduction from international diversification is that world markets fluctuate differently than our own. Other nations’ economic cycles are not always in phase. This translates to low correlations which can reduce variability in portfolio returns.

The different fluctuations can be caused by various factors. These factors include differences in: monetary policies; fiscal policies; industrialization; technology; laws; economic shocks; and other factors. {draw:frame} International diversification pushes out the efficient frontier. Risk is reduced for any given level of return, and return is enhanced for any given level of risk. An internationally diversified portfolio (represented by line 1,) has clear advantages compared to a domestically diversified portfolio (represented by line 2. ) Point B has the same return as Point A but has less risk.

Point C has the same risk as Point A but more return. Also, a point between B and C would have less risk and more return than Point A. Investing in emerging markets offer tempting advantages to investors. The volatile economies of countries considered to be in this category have a potential for extraordinary returns. A caveat to investors considering opportunities in emerging markets are the presence of unstable governments, the chance of nationalization, poor property rights protection, and large swings in prices. Emerging markets are far from a sure thing.

But, despite high individual risk, emerging markets can reduce portfolio risk. The volatile economies of these countries have such low correlations compared to the domestic market that they actually provide the greatest degree of diversification. Despite the strong argument for international diversification, there are some grounds to consider when investing. There are barriers to investing internationally. These include legal difficulties, lack of information, stringent tax regulations, and high transaction costs. These costs can reduce returns and must be considered when figuring returns.

As mentioned before, these barriers are diminishing. When investing internationally there are risks beyond the risk of individual securities or portfolios. There is liquidity risk, because it is often not as easy to sell international securities. There is also exchange risk when transferring the funds from international assets back to the home currency. This risk can be hedged through the use of currency futures contracts, but hedging increases transaction costs. Some investors actually prefer exchange risk because of the possibility of increased returns.

Some investors simply do not invest internationally because they have a degree of home bias. Investors in this category usually do not invest internationally because they are unfamiliar with international markets. They prefer domestic investing because they are familiar with the domestic market. Some investors in this category simply do not invest internationally because they do not want to support markets outside of the US. Despite the meager reasons for a home bias, there is a strong home bias among US investors. The organization, In the Money Investments (IMI), is a partnership formed by two financial professionals in the state of RI.

The company packages financial products together for its clients and charges various fees for the service which includes execution and account maintenance. The company services clients of all ages and incomes but primarily serves clients age 35-65 with greater than $100,000 in annual earnings and $300,000 of net worth who are seeking various investment goals including retirement, college savings, and wealth maximization. The company competes directly with other local investment firms as well as with the national firms such as Fidelity, Charles Schwab and others.

The company has offices in both Newport and Providence and employs 46 employees. The company has $500 million under management and annual net income of just over $1 million. The company’s primary strategic advantage is the level of trust that it has with its clients. This trust creates solid referrals, allows for a better working, long-term relationship. Its customers are not the type to “jump ship” after a single bad year. An increased investment product offering by IMI, specifically through adding internationally diversified investment products, is being investigated to see whether or not its loyal customers will adopt the products.

This increased product offering could lead to more satisfied investors which will increase word of mouth and lead to increased new customers. This will also lead to an increased investment level by investors as they see greater return for their levels of risk in their investment. The partners have requested a study to investigate the likelihood of its existing customer base adopting the internationally diversified products. They are worried about the customers adopting something that may be foreign to them as well as an investor home bias.

The research questions posed for empirical investigation are: Does investor satisfaction affect their willingness to invest internationally? Does investor investment aptitude affect their willingness to invest internationally? Research Problem In the Money Investments needs to know whether or not their existing client base will purchase a new internationally diversified product. Specifically we are looking at investor’s satisfaction with In the Money and the level of the investor’s investment aptitude in determining whether or not the investor would purchase an internationally diversified product.

The existing client base needs to be researched to see if they have these attributes that are being investigated and whether or not they will be likely to purchase the internationally diversified product. Hypotheses There are two hypotheses being examined in this study. They are as follows: H1: Advanced investors will be more likely to purchase an internationally diversified product. H2: Investors that have been satisfied in the past will be more likely to purchase an internationally diversified product. Variables Variables examined for this study are as follows: Independent Variable 1: Investor Ability.

Independent Variable 2: Investor Satisfaction Dependant Variable: Inclination to purchase an internationally diversified investment. The likelihood of an investor to purchase a company’s internationally diversified product is important for an investment firm to know before making a product offering. In this case, In the Money Investments has to take some consideration of the dimensions of the investment world that can affect that likelihood. The dimensions of the investment world that very well may be affecting that likelihood are:

• Investor Satisfaction;
• Investor Status;
• Investor Demographics;
• Current Macroeconomic Factors

Investor satisfaction can be determined by the image the investment firm portrays to the investor, the relationship the investor holds with the firm, the previous experiences in levels of returns and volatility the investor has in their portfolio. If an investor is satisfied with each of the listed elements, we can then measure the correlation between satisfied investors and their purchasing decisions for an internationally diversified product.

Investor status is a dimension that varies based on experience, education, level of wealth, and risk tolerance. These elements create a background or resume for an investor. Each of these elements can be combined to form a numeric representation of an investor’s investment ability. Using this numeric value, a status of the investor can be measured against their willingness to accept an international investment into their portfolio. Investor demographics is a dimension which can show patterns of acceptance among demographic groups.

Investors from certain countries or with certain birthplaces may be more or less likely to purchases internationally diversified products. Also, investors of different sex or age may be more or less likely to purchases Lastly, current macroeconomic factors ia a dimension which may affect an investor’s willingness to purchase an internationally diversified product. A poor market and recent terrorist attacks are example of this. Justification of the Problem In the Money Investments needs to know whether or not their efforts to include an internationally diversified product offering will be beneficial o their business. If the firm offers a product and it does not sell, the firm will lose money involved in presenting the product offering as well as in soft costs from time spent by members of the firm in investigating the offering. The firm is interested in offering the internationally diversified products because their customers desire more returns in their portfolios without increasing their current levels of portfolio risk. In order to increase market share and retain their current customers, they are looking to this avenue as a way to remain competitive. Significance of the study

This study would show the firm whether or not they should provide the product offering. It will allow them to investigate their client base’s determinants of their purchasing decision of internationally diversified investment products. Successful measurement of the client base’s determinants of their purchasing decision will allow In the Money Investments to forecast their sales and then perform profitability analysis on the new product offering Summary In the Money Investments is seeking to maintain market share and satisfy their customers’ increasing appetites for returns without being exposed to any additional risk.

Previous research has shown that international diversification is a way that this can be achieved. However, In the Money Investments needs to know whether or not a client would be willing to purchase a new product offering in this area. Internationally diversified investments are not for everybody and it needs to be known whether internationally diversified investment products are right for In the Money Investments client base. This study seeks to investigate that issue.

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