Country versus region effects in international stock returns

An empirical regularity in the portfolio diversification literature is the importance of country effects in explaining international return variation. A new decomposition here disaggregates these country effects into region effects and within-region country effects. Half of the return variation typically attributed to country effects seems attributable actually to region effects, a result robust across developed and emerging markets; the remaining variation is explained by within-region country effects. For the average investor, this means that diversifying across countries within Europe, for example, delivers half the risk reduction possible from diversifying across regions globally.