THE INTERNATIONAL DIVERSIFICATION PUZZLE IS WORSE THAN YOU THINK

Despite the growing integration of international financial markets, in vestors do not diversify internationally to any significant extent. We show that this ''international diversification puzzle'' is deepened o nce we consider the implications of nontraded human capital for portfo lio composition. While growth rates of labor and capital income are no t highly correlated within countries, we find that the returns to huma n capital and physical capital are very highly correlated within four OECD countries. Hedging human capital risk therefore involves a substa ntial short position in domestic marketable assets. A diversified worl d portfolio will involve a negative position in domestic marketable as sets.