Benefits of diversification in EU capital markets: Evidence from stock portfolios

Although financial integration has tended to increase in the European Union (EU), it is not yet completed and investments remain mostly domestic and highly concentrated. While the economic literature provides several explanations for the high level of home equity bias, it is inefficient from the point of view of investors. Using only available information when allocating portfolios, we examine the benefits of stock diversification within the EU over the period 2012-23. We find that investors from several EU countries significantly improve their Sharpe ratios by investing more in Central and Eastern European Countries (CEECs) and that optimal portfolios perform better in periods of low and medium volatility. Moreover, diversification gains are compatible with maintaining the same average level of institutional quality and political risk as in national reference portfolios. Investors would therefore benefit from easing cross-border investments within the EU and further developing equity markets in CEECs.