Home country bias

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Home country bias is the tendency for investors to focus their investments in their domestic markets.[1] Financial theory suggests that investors should construct their asset class exposure in line with global-market capitalization.[2] Canadian equities represent 3% of world stock markets at the end of 2013,[3] and 4% (as of November 28, 2014)[4] of developed market countries, excludes emerging markets. Similarly, Canada represents 2% of the world's fixed income markets.[5] Canada is the sixth largest stock market by capitalization and the bond market ranks in the world's top ten.[3]

Nevertheless, as of Feb. 2014, Canadian investors (presumably including institutions) had a 59% domestic allocation for equities.[2] In 2010 they had a 89% domestic allocation for fixed income.[5] The figures are probably higher for individual investors, especially on the fixed income side[citation needed]. This phenomenon occurs all over the world,[2][5] and is often intentional.

Home bias in fixed income

For Canadians, keeping all fixed income domestic has the following advantages:

  • matching the currency of expenses to the currency of assets[6]
  • simplicity
  • the domestic fixed income market is well diversified by issuer type (federal government and agencies, provinces, municipalities, corporate), term (short, medium, long), credit rating, etc.[citation needed]
  • the domestic market has historically provided returns and volatilities comparable to developed markets as a whole[citation needed]
  • better investor knowledge of domestic markets
  • no exposure to foreign currencies, which would add greatly to the volatility of fixed income investments
  • no additional costs in the form of higher management expense ratios (MERs) or currency hedging costs

Therefore it appears that the home bias of Canadian investors in largely justified for fixed income. However certain investors may still want to consider adding some foreign bonds to their portfolios.

Home bias in equities

Vanguard research lists the following possible causes of home bias for equities:[5]

  • a preference for the familiar
  • corporate governance issues for overseas companies and (historically) high costs to access foreign securities
  • liability hedging (domestic investor spending is influenced by domestic inflation and interest rates)
  • multinational companies provide international diversification (this is truer for US and European investors[citation needed])
  • limiting exposure to foreign currencies

Other arguments for investing mostly in Canadian equities are

  • the dividend tax credit (applies to unregistered accounts only)
  • no additional costs in the form of higher MERs or currency hedging costs

Arguments against too strong a home bias for Canadian investors are:

  • the Canadian stock market is highly concentrated in three sectors (energy, materials, financials) which are quite cyclical, and has significant under-representations in information technology, health care, consumer staples and consumer discretionary[5], relative to the rest of the world
  • issuer concentration. The Canadian market has 36% of its capitalisation in the top-ten stocks[2], compared to 17% for the US market[5]
  • global diversification can reduce the volatility of returns because the correlations coefficients between Canada and global stocks are less than one (rolling 36-month correlation coefficients have varied between 0.37 and 0.87 over the period 1972-2014[2])

Each investor has to evaluate the pros and cons of a strong home bias versus global diversification for equities, taking into account his/her personal situation. Financial Wisdom Forum members have indicated allocations to Canada ranging from 0% to 100% within the equity part of their portfolios. For a "balanced" portfolio with 40% fixed income and 60% equities, an easy approach is to split the equities into three thirds: Canadian equities, US equities and MSCI EAFE equities; this is what the model portfolios at Canadian Couch Potato do. Investors preferring a stronger home bias may instead divide the equities into half Canadian and half global, for example: this is what the FPX indices do.

See also

References

  1. Home Country Bias Definition | Investopedia, viewed January 1, 2015.
  2. 2.0 2.1 2.2 2.3 2.4 Pakula et al., Vanguard research, Global equity: balancing home bias and diversification - a Canadian investor perspective, July 2014, viewed Dec. 29, 2014
  3. 3.0 3.1 Credit Suisse Global Investment Returns Yearbook 2014, viewed January 1, 2015.
  4. MSCI World Index Fact Sheet, viewed January 1, 2015.
  5. 5.0 5.1 5.2 5.3 5.4 5.5 Philips et al., Vanguard research, The role of home bias in global asset allocation decisions, June 2012, viewed Dec. 29, 2014
  6. Re: How much in Canadian equities?, by forum member Shakespeare, direct link to post.

Further reading

External links