Abstract

We examine the relative benefits of industrial versus geographical diversification in

the sample of ‘G8+5’ stock markets in the period time from 1998 to 2007. Most of the
literature investigating in this issue relies on one specific methodology (Heston and
Rouwenhorst (1994, 1995)). However, this methodology has recently been criticizing
as being too restrictive. In this paper, we use a mean-variance approach instead. Our
findings show that one may expect that increased stock market correlation would
precipitate a move from geographical towards industrial diversification. This results is
contrast with the paper in 1990s but consistent with the recent papers.

Executive summary

The models of portfolio balance developed by Markowitz [51 and Tobin [8] explain
the real world phenomenon of diversified asset holdings elegantly and properly. The
models have been criticized, extended, and empirically tested; by now their basic
content has become economic orthodoxy. However, until late 1960, the issue of
international portfolio diversification benefits was raised and became controversial.
Through three decades, there is a variety of papers investigating on different markets
in different time periods confirming the gains of diversifying across countries.
Nevertheless, there is still a few of studies challenging that results and imply that
there is no evidence of international diversification benefits. The recent papers seem
to concentrate on examining whether the benefits of international diversification are
stable over time.

The question of whether international diversification outperforms industrial

diversification has been raised not so long quite early. However, until 1990s, it was
concentrated by a large amount of literature as Heston and Rouwenhorst (1994, 1995)
introduced a model of stock return that is capable of disentangling country and
industry effects and a constrained dummy variable regression estimation then. While
most of papers in 1990s indicated that country factors affected the stocks rather than
industry factors, the recent papers has showed the opposite results and imply a
structural change between country and industry effects composition.

Most of the previous papers reused the Heston and Rouwenhorst (1994, 1995)
methodology to examine this issue. However, this methodology has been criticized by
recent papers as being too restrictive. In this paper, we attempt to reinvestigate the
issue relating to international and industrial diversification with the other
methodology suggested by the most recent academic paper of Moerman (2008): using
mean-variance analysis.

Using the data consisting of 707 stocks over 13 members of ‘G8+5’ countries, we
argue that in some extent it is more global and comprehensive to investigate. We
provide some empirical results that industrial portfolio diversification now offer
greater benefits comparing to international portfolio diversification. This finding is
contrast with the previous papers in 1990s but consistent with the recent papers. The
result also offers some implications to international investors and risk managers.