Global Capitalization Weighted United States European Monetary Union United Kingdom Japan Equilibrium excess return 3.98% Volatility 9.33% Sharpe ratio 0.426 3.98% 10.21% 0.390 4.40% 12.15% 0.362 3.82% 11.25% 0.339 3.39% 13.25% 0.256 home bias. At what point do diversification gains begin to taper off? Consider first the incremental impact of international equity allocations on the Sharpe ratio. In the first 10 percent step toward a global capitalization weighted portfolio, the Sharpe ratio increases. The second 10 percent step also improves, but not as dramatically as the first, and the incremental impact of each succeeding 10 percent step is smaller than that of the preceding steps. Figure 11.2 shows, in percentage terms, this effect on euro-, sterling-, U.S. dollar-, and yen-based investors. According to the graph, a 20 percent step toward a global capitalization weighted portfolio produces, on balance, a 25 percent improvement in the Sharpe ratio. For example, the Sharpe ratio of a euro-based investor who makes a 20 percent step toward a fully diversified portfolio increases from 0.362 to 0.377. The Sharpe ratio improvement of .015 represents around 23 percent of the total potential improvement (i.e., from .362 to .426). The similarity of incremental diversification benefits is striking: Regardless of base currency, the benefits begin to taper off after potential equity diversification reaches 60 percent. And the impact on the Sharpe ratio correspondingly wanes when approximately 75 percent of the potential benefit has been achieved, irrespective of the base currency. For example, sterling-based investors who moved 60 100% 75% - 25% - ,-y ,v^   0% o% 20% 40% 60% Equity Diversification 80% 100%   ■U.S. :-- Euro U.K. Yen FIGURE 11.2 Incremental Impact of Diversifying Equity Exposure