Why is the variance of a portfolio of internationally diversified stocks likely to be lower than the variance of a portfolio of U.S. stocks?
What will be an ideal response?
With international stocks, the investor can diversify away U.S.-specific sources of volatility (e.g. U.S.–specific business cycle movements, changes in U.S. monetary policy, changes in U.S. interest rates, etc.). Technically, the variance of an equally weighted portfolio converges to the average covariance between these stocks when the number of stocks gets very large. The average covariance among U.S. stocks is higher than the average covariance among a set of U.S. and international stocks.
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