Industry versus Country Portfolio Diversification: from the Perspective of the US Investor

University essay from Lunds universitet/Nationalekonomiska institutionen

Abstract: This thesis examines the role of diversifying across different industries in determining equity index returns in contrast to the effect of diversifying across different countries. This research aims at investigating the increasing importance of industry diversification. Furthermore, it examines the optimal portfolio for a US investor when diversifying globally within different industries. For constructing the optimal portfolio for the US investor, the Sharpe ratio is applied. The portfolio theory developed by Markowitz (1952) is presented and the concepts of the optimal portfolio and Sharpe ratio are identified. The views of the main contributors to the topic of portfolio diversification are investigated. To offer contrasting views, a distinction is made between industry and geographic diversification strategies, and prior empirical findings are provided. The results support the principles of diversification and the portfolio theory developed by Markowitz (1952). Industry effects seem to be more significant compared to country effects in determining equity index returns. Therefore, evidence is found for the increasing importance of industry diversification, and hence the importance of diversifying within multiple industries cannot be ignored. Based on the finding of that an American investor should invest across industries rather than across countries, we give a recommendation for investing across particular industries, for which the lowest average correlations with other industries are obtained. For evaluating the stability of the composition of the optimal portfolio, we apply the out-of-sample method. We find results that are in accordance with most findings that report worse out-of-sample performance in terms of a lower Sharpe ratio. These results are further supported by various prior findings.

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