Working Paper: NBER ID: w24646
Authors: Luis M. Viceira; Zixuan Kevin Wang
Abstract: This paper conducts a theoretical and empirical investigation of global portfolio diversification for long-horizon investors in the presence of permanent cash flow shocks and transitory discount rate shocks to asset prices and returns. An increase in the cross-country correlations of cash flow shocks raises the risk of a globally diversified portfolio at all horizons. By contrast, an increase in the cross-country correlations of discount rate shocks has a muted effect on portfolio risk at long horizons and does not diminish the benefits of global portfolio diversification to long-term investors. Empirically, we find that increased correlations of discount rate shocks resulting from financial globalization appear to be the main driver of an estimated secular increase in the cross-country correlations of both stock and bond returns since the late 1990’s. Increased correlations of inflation shocks are also an important source of the shift in bond correlations. By contrast, we don’t find evidence of an increase in the cross-country correlations of equity cash flow news or stock market volatility shocks. Our findings imply that the benefits of global equity diversification have not declined for long horizon investors despite the secular increase in global stock correlations, while the benefits of global bond diversification have declined.
Keywords: global portfolio diversification; long-horizon investors; cash flow shocks; discount rate shocks
JEL Codes: F21; F3; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in cross-country correlations of cash flow shocks (F65) | increases risk of globally diversified portfolio (G11) |
| increase in cross-country correlations of discount rate shocks (E43) | muted effect on portfolio risk at long horizons (G40) |
| correlated discount rate shocks (E43) | minimal effect on long-run return correlations (C10) |
| increase in correlations of bond cash flow news (G19) | increases risk of global bond portfolios at all horizons (F65) |
| benefits of global equity diversification (F62) | not diminished for long-horizon investors (G40) |
| benefits of global bond diversification (G15) | decreased for long-horizon investors (G40) |