The diversification hypothesis

When the assumption of risk neutrality is relaxed, risk becomes another factor upon which the FDI decision is made.According to the diversification hypothesis, the choice among various projects is guided not only by the expected rate of return but also by risk, as represented by the variability of the rate of return.The same idea of reducing risk via diversification that is relevant to portfolio investment is used here.Because of risk aversion, a rate of return differential will not induce capital flows in one direction until the differential disappears via arbitrage.