Staff Report 398

The International Diversification Puzzle Is Not as Bad as You Think

Fabrizio Perri | Monetary Advisor
Jonathan Heathcote | Monetary Advisor

Published October 1, 2007

In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.

Published In: Journal of Political Economy (Vol. 121, No. 6, December 2013, pp. 1108-1159)

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