Benefits of International Diversification of Portfolios: Using International Equity and Bonds

Much academic research has been completed on the use of portfolio optimizers in an international setting. Many optimizers use historical data and almost all allow for short sales. Some researchers have begun to question the output from such strategies. While some papers have tackled the problem of finding reasonable estimates for risk, the focus in this paper is on the inherent risk of investing in the tangency portfolio while allowing short sales. To test this theory, I first used historical data to test the validity of the theory that diversifying into international stock and bond index investments can provide gains to a US investor. Second, I performed the same test but with quarterly portfolio revision based on four separate strategies, two with short sales and two without. Last, I compared the results to those of an investor who followed two passive strategies. I found that while there was evidence that international diversification did provide US investors with an opportunity to increase returns, the risk adjusted return was not superior to that of the passive strategies. I also found that the use of short sales greatly increased the overall risk of the portfolio.