I recently had my University of Buffalo graduate student of financial engineering, Shwetha Narayan Iyengar complete an analysis on the diversification effect of adding international stock to a stock portfolio.
The study summarized below is not a recommendation , rather it shows how adding international stocks can reduce overall risk and improve return.
There is debate on how much non-us stock should be in stock portfolio. The results do seem to support those that argue that investors should hold stocks in proportion to their weighting in the mix of all stocks issued by all nations. The US currently makes up about 45% of the global capital market.
Keep in mind that this analysis does not include emerging markets or factor in value or small cap effects. It does support a diversification into international stocks when building your stock portfolio.
The summary:
Analysis of total US market vis-à-vis the other developed markets in a portfolio.
The CRSP 1-10 Index represents the total US cap weighted equity market. It measures the performance of all stocks aggregated across NYSE, AMEX and NASDAQ markets, spilt in deciles from large cap to small cap. MSCI EAFE index measures the equity market performance of developed markets outside of the U.S. & Canada and includes Europe, Australia, New Zealand (Australasia) and Middle East
Annualized returns and Standard deviation (measure of risk/volatility) for CRSP and EAFE for a period from 1970- 2010 are as provided below,
| Annualized | Returns | STD deviation |
| CRSP1-10 | 9.88% | 16.13% |
| EAFE | 9.94% | 17.25% |
Portfolio with 45/55 ratio of CRSP 1-10/EAFE gives the highest return for risk ratio (Sharpe ratio) and to further validate, a Monte -Carlo simulation value averaged over 3 independent simulations provides a higher value at 90 percentile or 10% probability of going above the value. (Monte Carlo is a statistical tool that will estimate probable outcomes for a particular set of risk and return inputs)
| Weights | ||||||||||
| CRSP1-10 | 55% | 60% | 65% | 70% | 75% | 80% | 85% | |||
| EAFE | 45% | 40% | 35% | 30% | 25% | 20% | 15% | |||
| Return Portfolio | 10.196% | 10.185% | 10.168% | 10.145% | 10.116% | 10.081% | 10.040% | |||
| Std deviation Portfolio | 14.910% | 14.899% | 14.926% | 14.989% | 15.089% | 15.226% | 15.400% | |||
| Sharpe ratio | 0.311938 | 0.311430 | 0.309728 | 0.306892 | 0.302936 | 0.297911 | 0.291883 | |||
| | | | | | | | | |||
| Wealth at retirement (90-percentile) from Monte Carlo simulation | ||||||||||
| Scenario 1 | $4,893,889 | $4,590,990 | $4,450,640 | $4,763,008 | $4,428,423 | $4,755,993 | $4,338,645 | |||
| Scenario 2 | $4,593,936 | $4,237,107 | $4,514,705 | $4,570,777 | $ 4,709,112 | $4,748,913 | $ 4,483,666 | |||
| Scenario 3 | $4,610,162 | $4,517,348 | $ 4,627,469 | $4,369,035 | $ 4,385,526 | $ 4308,407 | $ 4,631,853 | |||
| Average, Wealth at retirement (90-percentile) MonteCarlo simulation | $4,699,329 | $4,448,482 | $4,530,938 | $ 4,567,607 | $ 4,507,687 | $4,604,438 | $ 4,484,721 | |||
The most optimum scenario is 55/45 portfolio. A higher weighting of CRSP 1-10 reduces the Sharpe ratio, the return and the final value of the portfolio. If the analysis is expanded using higher weights for the MSCI EAFE and lower weight for CRSP 1-10 , the result does not vary much and the most optimum portfolio still remains as 55/45 .
