Mention “home bias” to the average Canadian, and you may get an earful on the last time his favourite hockey team was robbed by a ref in an opponent's rink. Mention it to the average economist, and you'll probably get an earful on inefficient investment decisions. In financial market circles, home bias refers to the well-documented and persistent tendency among investors to keep a disproportionate share of their portfolios in domestic assets, seemingly “over-discounting” the riskiness of foreign investments, and so driving efficiency-loving economists nuts by forgoing opportunities to enhance return and diminish risk by diversifying abroad.
Home bias will probably always be with us–domestic investments inevitably seem more comfortable. But the bias is fading. Alan Greenspan explained it well in one of his last speeches as Fed chairman: “Starting in the 1990s, home bias began to decline discernibly, [the consequence of a] dismantling of restrictions on capital flows and the advance of information and communication technologies that has effectively shrunk the time and distance that separate markets around the world. The vast improvements in these technologies have broadened investors' vision to the point that foreign investment appears less risky.” Canada shared in this global trend for much of the past couple of decades. Between 1993 and 2002, the share of foreign assets in Canadians' registered pension plan portfolios more than doubled, from 11.6% to 24.6%. That surge reflected not only Canada's sharing in the worldwide improvement in information about and access to foreign markets, but also the loosening of the Canadian government's policy restrictions on holdings of foreign assets–and, without doubt, the Canadian dollar's seemingly interminable weakness.
Home bias appears to have been declining even faster of late. Between 2002 and 2004 (the last year for which we have complete global data), investors increased their positions in foreign securities by more than $9,000,000,000,000, an increase of 65%, as the upturn in the business cycle and the ongoing integration of China and other countries into the global economy invigorated investors' risk appetites. Country-level data suggest cross-border investment has accelerated even further more recently.
But not here, it appears. Canadians seem to have bucked the trend in recent years–despite the scrapping of the foreign content limits last year. Rightfully so, it must be said, as the returns on domestic assets have been among the best anywhere. In currency-adjusted terms, Canada's S&P/TSX composite has outperformed the S&P 500 by a remarkable 79 percentage points since the end of 2002. About half of that has been in the Canadian dollar's historic appreciation through the period, which has made foreign investment of any kind a difficult, and likely losing, proposition. Concentrating on Canada has been the path to prosperity.
Nothing wrong with that–so long as Canadian markets keep outperforming. But that can't continue indefinitely. Canadians have, in the meantime, appeared to fall well behind the rest of the world in diminishing their home bias, so some catch-up looks inevitable, particularly given how small and increasingly narrow the Canadian market is. Of course, the process of achieving a more diversified international portfolio will involve substantial outflows of capital from Canadian markets, tending to unwind some currency and asset market gains, which itself may elicit further diversification abroad. Thus may the virtuous Canadian investment circle of recent years turn vicious.
Clearly, no such vicious circle is now under way. But the plausible catalyst for it to get started is a weakening in the fundamental supports that got Canada's currency and market strength going in the first place. Robust global growth, leading to surging demand for commodities, has been the greatest of these. The emerging bust in the U.S. housing market, with its potential effects on the American consumer and broader economy, is an evident threat there.
In short, home has been a great place to be for Canadian capital this cycle. It won't remain such a great place indefinitely. When that happens, there may be a lot of investors trying to get through an awfully small door. And those still sitting home may find it somewhat less comfortable than they do now.
Canadian stock markets may be world-beaters now, but that can't last forever