Who Holds Foreign Stocks and Bonds? Characteristics of Active Investors in Foreign Securities

Abstract

Abstract We study the behavior of active individual investors who hold foreign stocks and bonds directly. Using the Survey of Consumer Finances, we determine the demographic, financial, and behavioral characteristics that predict the likelihood of direct investments in foreign stocks and bonds. Our main findings are: (1) while aggregate data indicate substantial bias, within the group of active individual investors in foreign stocks, there is no evidence of bias, and (2) age, financial wealth, and proxies for investor confidence are positively related to direct ownership of foreign stocks and bonds, while proxies for lack of financial sophistication have a negative effect. © 2009 Academy of Financial Services. All rights reserved. JEL classification: G11 Keywords: Home bias; Individual investors; Foreign investments 1. Introduction There is a worldwide trend to shift the burden of investing to individual investors. Defined benefit plans are being replaced by defined contribution plans; in the United States, there were talks of privatizing Social Security, which have generated heated debates. An important policy question is whether or not individual investors are financially sophisticated enough for the task. This paper explores the extent to which individual investors understand the benefits of international diversification. The benefits of international diversification have been known for some time, and discussed in numerous academic papers starting with the seminal work of Levy and Sarnat (1970). Through various innovations, investing in foreign financial assets has been made less complicated, even for individual investors. As for the desired proportions, the international version of the Capital Asset Pricing Model (ICAPM), for example, suggests that investors should invest in the global market portfolio, with the weights being proportional to each country's capitalization in the world market. In Fig. 1, we present the U.S. equity and bond market capitalizations as a percentage of their corresponding world market. From 1990 to 2005, the share of U.S. equities in the world equity market ranged from 35% to 52%, whereas the share of U.S. bonds fluctuated from 39% to 47% of the world bond market. Hence, according to the ICAPM, a U.S. investor should hold about 50% of her equities in stocks from, say, 1997 on, and on average about 45% of bonds during the same period. Although the ICAPM may represent a simplified approach to international diversification, several academics and practitioners alike have arrived at comparable proportions of equities (henceforth, domestic refers to United States) as they construct the efficient portfolio. These proportions are in the range of 50% to 70% of stocks (Li et al., 2003; the Robeco Group, 1997; Miffre, 2007; Solnik, 2000). However, in reality, individual investors never seem to hold the global market portfolio. Instead, they keep a disproportionately large share of equities in their portfolios. In Fig. 2, we present the actual proportions of aggregate equity and bond holdings in the United States. If one compares Figs. 1 and 2, the actual holdings of both equities and bonds are far above the expected amounts. This apparent inconsistency has been dubbed the home bias puzzle in the financial economics literature. One may argue, however, that not all foreign stocks are available to a investor. In this case, the share of equities in the global portfolio of marketable stocks would be higher than what Fig. 1 suggests, which lessens the severity of the bias. Nonetheless, the growing market of American Depository Receipts (ADRs)1 as well as countryspecific exchange traded funds (ETFs) provides investors with an additional opportunity to diversify internationally without having to incur higher transaction and information costs. …

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