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When you think of investing in the stock market where do you envision the companies you invest in are located? If you’re like most investors, the answer would be whatever country you live in. Research has shown that investors believe “there’s no place like home”. In this article, I will discuss home-country bias and the impact it has on your investment portfolio.
In 1991, Ken French and James Poterba published a paper in the American Economic Review titled “International Diversification And International Equity Markets”. This was the first research that I am aware of that documented the phenomenon known as home country bias.
French and Poterba found that at that time investors portfolios in different countries across the world held between 80%-98% of their portfolio in stocks from their home country. Investors in every country were largely ignoring the opportunity to invest in international stocks.
It might make sense for U.S investors to ignore investing in Canadian stocks. The U.S economy is much larger and more diverse. But Canadians ignore investing in U.S stocks in equal measure. No matter where you go, investors, seem to prefer investing in their home country.
If you think about it home country bias makes perfect sense. Local media in every country fixates on the ups and downs of the local stock market. As a Canadian, I am unlikely to know if the U.K or Japanese stock markets experience a bull run.
If the Canadian stock market goes on a bull run, every newspaper and Canadian media outlet will be loudly broadcasting that fact daily. I’m more likely to feel like I’m missing out and be more likely to invest in the Canadian stock market.
Put simply, home country bias is simply the investors preference to invest in what they know and feel comfortable with.
Home country bias prevents an investor from geographically diversifying their portfolio. By investing in international stocks you gain exposure to economies outside of your home country.
If you have all of your money invested in one country and that countries economy underperforms relative to the global economy, your portfolio will suffer. If you have your money spread throughout multiple countries. even if one country is underperforming that might be offset by another country overperforming.
Beyond gaining exposure to other economies a globally diversified portfolio can ensure you don’t miss out on the companies that will drive the stock market in the future.
As I’ve written previously, a very small number of stocks drive the return of the global stock market. Not only do we have no idea which stocks will drive future market returns we have no idea which country those companies will be located in.
If you have 100% of your portfolio allocated to U.S stocks you will miss out on potential returns if the next Apple or Microsoft is in Germany or China.
Adding in international stocks to your portfolio also reduces the overall volatility of your portfolio.
In a paper written by Vanguard in 2019, their research determined that investors who allocate roughly half of their portfolio to international stocks experience the least volatility. This finding fits with the theory of diversification. A well-diversified (which includes global diversification) portfolio will be less volatile than a highly concentrated portfolio.
Before you go out and dump all your stocks from your home country let me make the case for when it is logical to embrace home country bias.
If you have maxed out your tax selected accounts like a 401k (U.S) or an RRSP (Canada) and you are investing in a taxable account it might make sense to overweight your portfolio towards stocks from your home country.
The reason is that most governments provide a tax incentive to invest in stocks from your home country.
I am Canadian, so I will discuss taxes from the perspective of a Canadian investor. I suspect in most countries, your government will provide similar (but not identical) tax incentives as the Canadian government provides me.
When I invest in an ETF that tracks the Canadian stock market, the dividends paid to me are what are called “eligible dividends”. These dividends receive a preferential tax treatment compared to dividends from an ETF that invests in international stocks.
I live in the province of Ontario in Canada where the highest marginal tax rate is more than 53%. If I am in that 53% tax bracket, I would only pay 39% on my “eligible dividends” I receive from publicly traded Canadian companies. Any dividends I receive from international companies would be taxed at 53%.
Here is the real kicker. The lower my tax bracket the more incentive I have to invest in Canadian stocks.
I won’t get into the complicated nature of how dividends are taxed in Canada. The primary take away is that at every income level, dividends from Canadian companies are given tax preference compared to dividends from international companies.
I strive to make intentional choices with my money. That applies to how I allocate my asset allocation and asset location.
In my tax-sheltered accounts where I don’t have to pay taxes on dividends, I invest 100% in index funds that track the global stock market. Since Canada is roughly 3% of the global stock market, roughly 3% of the value of these funds is invested in Canadian companies.
This provides me the diversification benefits of investing in international stocks. Since these investments are in tax-sheltered accounts I do not need to worry about the tax consequences.
In my taxable investment account, I invest 100% in Canadian stocks. I would not say I am giving into home country bias. I am simply responding to the tax incentives that the Canadian government has provided me.
By making intentional decisions about my asset location I get the best of both worlds; reduced volatility, and tax efficiency.
How do you allocate your portfolio? Do you invest in international stocks? Do you consider asset location as part of your investing strategy? Let me know in the comments below.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.