Journal of International Money and Finance
21 (2002) 981–1011
www.elsevier.com/locate/econbase
Are the gains from international portfolio
diversification exaggerated? The influence of
downside risk in bear markets
K.C. Butler a,∗, D.C. Joaquin b
a Department of Finance, Michigan State University, East Lansing, Michigan, 48824, USA
b Department of Finance, Insurance and Law, Illinois State University, Normal, Illinois, 61790, USA
Abstract
The fundamental rationale for international portfolio diversification is that it expands the
opportunities for gains from portfolio diversification beyond those that are available through
domestic securities. However, if international stock market correlations are higher than normal
in bear markets, then international diversification will fail to yield the promised gains just
when they are needed most. We evaluate the extent to which observed correlations to monthly
returns in bear, calm and bull markets are captured by three popular bivariate distributions:
(1) the normal, (2) the restricted GARCH(1,1) of J. P. Morgan’s RiskMetrics, and (3) the
Student-t with four degrees of freedom. Observed correlations during calm and bull markets
are unexceptional compared to these models. In contrast, observed correlations during bear
markets are significantly higher than predicted. Higher-than-normal correlations during
extreme market downturns result in monthly returns to equal-weighted portfolios of domestic
and international stocks that are, on average, more than two percent lower than those predicted
by the normal distribution. If the extent of non-normality during bear markets persists over
time, then a US investor allocating assets into foreign markets might want to allocate more
assets into foreign markets with near-normal correlation profiles and avoid markets with
higher-than-normal bear market co-movements.
2002 Published by Elsevier Science Ltd.
JEL classification: G15; G11; C15; C34
Keywords: Bear...