International Portfolio Diversification and the Issue of Estimation Errors in Mean-Variance Efficient Portfolios: A German Investor Perspective
The following study applies a popular asset allocation framework—the mean-variance optimization—to examine the potential international diversification benefits for the German investor, from an ex-post perspective, over a period of almost 15 years. The effect of a German home bias is explicitly considered in the analysis. Moreover, the effects of the recent period of severe stock market stress (2007–2008) are analyzed for further comparison of the benefits of international diversification. However, practical implementation of the traditional mean-variance optimization is limited. The procedure suffers, almost always, from estimation errors. Estimation errors refer to the fact that the input parameters are estimated from past data, and as such, are likely to contain various errors, such as measurement errors, small sample biases, and noises. An application of a Monte Carlo simulation is used to illustrate this potential shortcoming. Furthermore, a resampling procedure known as the resampled efficient frontier is introduced to account for estimation errors in mean-variance optimized portfolios. The analysis shows that, in almost all cases, internationally diversified portfolios are superior to regionally or purely domestically diversified portfolios for the German investor. An international portfolio, where estimation errors are explicitly considered, still performs better than purely domestically diversified indices, and the resampled efficient frontier, as a large- scale sensitivity analysis, is plotted to improve the quality of the mean-variance optimized international portfolio.
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