Financial Markets, Diversification, and Allocative Efficiency: International Evidence

Abstract

We study the effect of financial markets on "optimal" diversification defined in the spirit of mean-variance efficiency as a pattern of output reallocation across industrial sectors which simultaneously accounts for the sectors' growth, volatility, and correlations. Our findings imply that financial markets increase substantially the speed with which the observed sectoral allocation of output converges towards the benchmark optimally diversified one. This convergence is relatively faster for sectors that have a higher "natural" long-term risk-adjusted growth and are more dependent on external finance. Our results are robust to different benchmarks, to the endogeneity of finance, and to accounting for investor protection, contract enforcement, and barriers to entry. Crucially, the observed patterns disappear when we employ classical measures of diversification based on the mechanical spreading of output across sectors.