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Home bias is a recognized global phenomenon where investors intentionally overweight domestic holdings at the expense of foreign securities. Last time, I looked at the main consequnces of home bias. Now I want to drill deeper into the consequences of home bias for Canadian investors.
Modern portfolio theory allows for the creation of portfolios that have a lower risk per level of return than individual assets held in isolation. This is due to the diversification benefit, where combining securities, sectors, and countries with less-than-perfect correlations results in more efficient portfolios.
An efficient portfolio can be created for each level of risk, represented as the yellow line or the efficient frontier in Figure 5 in my previous article. The “World” portfolio is the most efficient portfolio for investors to choose. While a fully market-proportional equity portfolio may be impractical or unpreferable for most Canadian investors, maintaining a set allocation represents a reasonable tradeoff between diversification and investor preferences.
The primary challenge with this approach is determining equity allocation to Canadian versus non-Canadian equities.
A key factor to consider in determining how much to allocate outside of Canadian equity market is diversification. One way to evaluate the expected diversification benefits of international equities is to analyze the impact on portfolio volatility as incremental allocations of international equities are added to a domestic equity portfolio.
Figure 1 displays the results of a minimum-variance analysis, with a focus on assessing volatility of investment portfolios. The analysis considers a 100% equity portfolio and a balanced portfolio of 60% stocks and 40% bonds, gradually decreasing exposure to Canadian compared with global equities while starting with a portfolio fully allocated to Canadian equities. Notably, the curves representing both equity-only and balanced (60% equity/40% bonds) portfolios demonstrate that incorporating global equity exposure would have reduced average volatility over the studied period.
That said, the marginal benefit of international diversification declines as allocations to international equities increase. A semi-U-shaped curve in Figure 1 illustrates that portfolio volatility begins to rise with allocations of greater than 70% to international equities. Looking at the data, the optimal asset allocation for Canadian investors is a 30% allocation to Canadian equities and a 70% allocation to international equities because it has shown to minimize the long-term volatility of their portfolio.1 Also, by combining the analyses in Figures 4 and 5 in my previous article, we can understand that maintaining a significant level of home bias implies explicitly taking on the idiosyncratic risk of Canada, deviating from the efficient frontier.
When it comes to sizing an appropriate home bias, we take into consideration factors such as investors’ home-country preferences, potential volatility of returns and volatility reduction from diversification and imperfect correlations achieved thorough global exposures, the degree of market/sector concentrations, relative implementation costs (including taxes and trading costs), and currency effects.
Our research shows that Canadian and other developed countries’ investors may have realized the benefits of international diversification as shown by the declining preference for domestic equities from 2012 to 2022, as shown in Figure 2A. In short, Canadian investors are increasingly tapering down their level of home bias by diversifying to international equities (Figure 2B). And this is a trend seen across the globe in other developed markets.
Moreover, looking at the asset allocation for global pension assets over the last two decades, the data reveal a notable decrease in the degree of home bias in equities. Specifically, the average weight of domestic equities has declined from 67.1% in 2002 to 37.7% in 2022 across Australia, Canada, Japan, Netherlands, Switzerland, UK, and US. In the last decade, the United States has exhibited the largest allocation to domestic equities, whereas Canada, Japan, and Switzerland have had the lowest allocation.2
Home bias is a common, global phenomenon where investors overweight domestic holdings at the expense of foreign securities. Canadian investors have a significantly high home bias, allocating 52.2% of their total equity allocation to Canadian equities, which is over 15 times overweight. This bias results in security and sector concentration, leading to an inefficient portfolio allocation and exposure to considerable idiosyncratic risk that can be diversified away by allocating to both Canadian and global equities in a portfolio.
Yet some level of home bias makes sense for Canadians because there will always be a local preference for Canadian companies and securities that are familiar and in closer proximity. Vanguard maintains that 30% Canadian equities and 70% international equities is the optimal asset allocation for Canadian investors based on historical evidence on minimizing volatility, declining trend of domestic equity preferences for both individual and pension investors, and after considering other factors such as benefits of diversification, portfolio implementation costs, favourable tax considerations, and currency effects.
Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.
Notes
1. Based on minimum variance analysis on historical data from January 1999 to June 2022. Index returns reflect the MSCI World Index and the respective MSCI indexes for each country in the World index. The efficient frontier does not reflect actual data or returns and is theoretical in nature. Global return data covers the period January 29, 1988 through May 31, 2023; Canada return data covers the period January 30, 2004 through May 31, 2023; Germany return data covers the period February 26, 1999 through May 31, 2023; Japan return data covers the period February 26, 1971 through May 31, 2023; United Kingdom return data covers the period February 26, 1971 through May 31, 2023; Australia return data covers the period February 26, 1971 through May 31, 2023; EU return data covers the period February 26, 1999 through May 31, 2023; and Emerging Markets return data covers the period January 29, 1988 through May 31, 2023. The return points are historical, while the curve is purely theoretical and forward looking.
2. Thinking Ahead Institute: Global pension asset study 2023
References
• Renzi-Ricci, G., Zhu, V., Donaldson, S.J., Ahluwalia, H., 2021 Vanguard’s framework for constructing globally diversified portfolios
• Renzi-Ricci, G., Zhu, V., Donaldson, S.J., Ahluwalia, H., 2021 Global equity investing: The benefits of diversification and sizing your allocation
• Scott, B. J., Balsamo, J., McShane, K. N., & Tasopoulos, C., 2017. The Global Case for Strategic Asset Allocation and an Examination of Home Bias. Vanguard Research.
• Pakula, D.C., Walker, D.J., Kwon, D.T., Bosse, P.M., Maciulis, V., & Philips, C.B. 2014., Global equities: Balancing home bias and diversification – A Canadian investor’s perspective. Vanguard Research.
• Scott, Brian J., James Balsamo, Kelly N. McShane, and Christos Tasopoulos, 2017. The Global Case for Strategic Asset Allocation and an Examination of Home Bias. Valley Forge, Pa.: The Vanguard Group.
• International Monetary Fund, 2019. Coordinated Portfolio Investment Survey. Washington, D.C.: IMF.
Disclaimer
© 2023 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared July 5, 2023, on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.
The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.
Certain statements contained in this material may be considered “forward-looking information” which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.
This material is not a recommendation, offer or solicitation to buy or sell any security, including any security of any investment fund or any other financial instrument. The information contained in this material is not investment advice and is not tailored to the needs or circumstances of any investor, nor does the information constitute business, financial, tax, legal, regulatory, accounting or any other advice.
The information contained in this material may not be specific to the context of the Canadian capital markets and may contain data and analysis specific to non-Canadian markets and products.
The information contained in this material is for informational purposes only and should not be used as the basis of any investment recommendation. Investors should consult a financial, tax and/or other professional advisor for information applicable to their specific situation.
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