Domestic and Foreign Country Bias in International Equity Portfolios

Abstract

I provide an analysis of the home bias in international equity investments using data for the year-end 2006. Distinguishing two components of the local equity preference – the “domestic country bias” indicating whether local investors overinvest the domestic market, and the “foreign country bias” indicating whether investors overinvest or underinvest a particular destination – I find that emerging countries’ investors hold systematically larger shares in their local markets compared to their counterparts in developed countries. Disaggregation of the cross-border assets by destinations reveals mixed patterns as captured by the country bias ratios. While investors generally allocate trivial portions to some foreign markets and completely disregard others, I uncover several positive country bias ratios suggesting that the destination market is overweighted by the source market’s investors. Geographical proximity is central to characterize such bilateral holdings. Finally, investors prefer to invest mostly in developed countries with larger equity markets so that the amounts held in only a handful of destinations suffice to account for a big part of the existing foreign equity. I refer to this observation as the “geographical shrinkage” in portfolio investments along the well-documented home bias puzzle.