Academic journal article Academy of Accounting and Financial Studies Journal

A New Selection Strategy for Portfolio Diversification in the European Union

Academic journal article Academy of Accounting and Financial Studies Journal

A New Selection Strategy for Portfolio Diversification in the European Union

Article excerpt

ABSTRACT

Benefits of portfolio diversification transpire from the motivation of risk minimization and maximization of the expected return. Potential for global portfolio diversification has been recognized by the investors in recent years. A portfolio with the highest level of expected return for a given level of risk is said to be mean-variance efficient. Therefore, the risk-reward ratio of a globally diversified portfolio is expected to be optimum.

This paper proposes a method of portfolio selection on the basis of partial correlation criterion by seeking market relationship that is independent of world market. Portfolios are constructed using both partial correlation approach and Markowitz (or correlation) approach in the EU for two different home markets France and Germany. The performance of these portfolios has been measured for three different strategies to determine the proportion of asset allocation in the portfolio. The findings of this study suggest that the optimum strategy that minimizes the coefficient of variation to determine the proportion of asset allocation has a better potential for diversification. Furthermore the results reveal that, the partial correlation approach produces superior portfolios as opposed to Marko witz approach based on Sharpe 's performance measure.

INTRODUCTION

The benefits of global portfolio diversification have been largely accepted and recognized by the investors in recent years. An extensive literature discussion in this research area appears in Solnik (1988). Benefits of portfolio diversification emerge from the motivation of minimizing risk and maximizing the return. One measure of portfolio risk is the portfolio variance. Portfolio variance depends on the variance of each asset and also the correlations among themselves. Thus, correlation plays a vital role in the creation of diversified portfolio. Researchers (Grubel, 1968; Bailey & Stulz, 1990; Divecha et al, 1992; Michaud et al. 1996) have shown that benefits of portfolio diversification are stemming from the relatively low correlations between equity markets in the global arena. Yet, the spurious nature of correlation between country indexes due to global market dominance may impact the likely benefits of global investment. A natural prevention of global market dominance in diversified portfolio creation is to use partial correlation with respect to the world market.

This paper explores the opportunities for investment diversification in the EU stock markets by employing partial correlation in portfolio creation. Research studies conducted recently showed that the central European stock markets are not yet integrated with the stock markets of the EMU members such as Germany. Gilmore and McManus (2002) conducted co-integration tests on stock markets of Germany, Poland, the Czech Republic and Hungary. They found no long-term relationship between the German market and the three central European markets. Naidu and Choudhury (2004) conducted co-integration tests on stock markets of France and the ten new members of the Union and found that the stock markets are not yet integrated. The lack of integration among the 25 EU stock markets offers an opportunity for investors in and outside of EU to diversify and reduce risk. Gilmore and McManus (2003) examined this very specific issue. They found that the U.S. investors and German investors can reduce risk by diversifying their equity portfolios into the central European equity markets such as Poland, Czechoslovakia, and Hungary. Naidu and Choudhury (2006) proposed that country's beta estimate offers a better insight to judge the extent of risk reduction achievable through international diversification.

Here, we propose partial correlation criterion to select assets in the portfolio and optimization of coefficient of variation to determine the proportion of asset allocation in EU countries for French and German investors. We evaluate their performance using Sharpe's Index and compare them with portfolios created by simple correlation criterion. …

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