How To Diversify Internationally: A Comparison of Conditional and Unconditional Asset Allocation Methods

To obtain the maximum benefits from diversification, financial theory suggests that investors should invest internationally because of the larger potential for risk reduction stemming from the lower correlation exisiting between assets of different countries. The question that we raise in this paper is how to choose the best mix of countries to diversify internationally? We compare several methods of asset allocation from a Swiss perspective over the period 1988-2001. We simulate different investment policies and compare conditional and unconditional methods. We find that conditional methods, that explicitly assume time-variation in expected returns, outperform all other asset allocation methods.