International portfolio choice and political instability risk: A multi-objective approach

The benefits derived from international portfolio diversification into foreign nations (including the less developed countries) are well documented, yet this practice is discouraged due to market imperfections such as political instability. In practice, nations may be differentiated further by many aspects, such as border controls or political and social trends, which constrain private transactions and financial decisions. This paper attempts to examine (1) whether the home asset bias in a portfolio holding is associated with higher political instability risk, and (2) to what extent international diversification among stocks, in the presence of such risk, outperforms domestic stock portfolios. Using alternative instability risk proxies in the context of a discrete-time version of mean–variance framework, we corroborate the impact of this type of risk on international portfolio investment decisions.

► We present a multi-objective methodology for derivation of the efficient frontier.
► We address the home equity bias in the presence of political instability risk.
► As instability risk increases, a revision of the optimal asset allocation favoring home countries.
► Both used proxies (CPI and SEG) are relevant to industry practitioners, and academics.