While global diversification is a cornerstone of modern investing, maintaining a healthy overweight to your domestic market can actually improve portfolio efficiency.
The Global Imperative
Global diversification is one of the few 'free lunches' in finance, yet it is a meal many investors refuse to eat. In 1991, economists Ken French and James Poterba documented a phenomenon they called 'home country bias,' noting that investors in major economies held between 80% and 98% of their portfolios in domestic stocks. While those numbers have moderated over the last three decades, the tendency remains pervasive. In Canada, for instance, domestic stocks make up only about 3% of the global market, yet the average Canadian investor allocates closer to 60% of their equity portfolio to local companies.
The logical argument for spreading your bets across the globe is ironclad. Long-term stock returns are driven by country-specific economic performance; tethering your entire financial future to a single nation’s economy is a concentrated risk that can prove disastrous if that nation enters a period of secular decline. Furthermore, global returns are often driven by a tiny minority of winners. Research shows that from 1990 to 2018, just 1.3% of global stocks accounted for all net wealth creation. Since we cannot predict which companies or countries will produce these outliers, we must own everything.
The Volatility Paradox
If global diversification is so vital, one might assume that the optimal portfolio should mirror the world’s market-capitalization weights. However, the relationship between diversification and risk is not a straight line. According to Vanguard’s research on strategic asset allocation, the maximum reduction in volatility for a Canadian investor is typically achieved when they allocate between 50% and 60% of their portfolio to international stocks—not the 97% suggested by market-cap weights. Moving beyond that threshold can actually increase expected volatility in certain models.
This suggests that the marginal benefit of adding foreign stocks declines rapidly once a solid international foundation is established. While we should be wary of over-relying on any single model, these findings indicate that maintaining a substantial home bias is not necessarily a departure from prudent risk management. In fact, for many investors, a domestic allocation that significantly exceeds their country's global market share may be the most efficient way to dampen portfolio swings.
The Friction of Fees and Taxes
Beyond theoretical volatility, real-world investors must contend with the tangible costs of crossing borders. In the era of low-cost indexing, domestic ETFs are often the cheapest tools in an investor's kit. While a Canadian total market fund might carry a management expense ratio (MER) of just 0.06%, funds covering international developed or emerging markets can cost four times as much. These small percentages compound over decades, creating a persistent drag on foreign returns.
Taxes represent an even larger hurdle. In Canada, eligible domestic dividends are taxed more favorably than foreign income due to the dividend tax credit. At the highest marginal rates, the difference can be staggering—roughly 39% for domestic dividends versus over 53% for foreign ones. Additionally, foreign withholding taxes can quietly erode returns in registered accounts like the RRSP or TFSA. These 'hidden' costs, which can range from 0.20% to 0.70% annually, make domestic equities inherently more tax-efficient for the local investor.
The Behavioral Hedge
Investing is as much a psychological challenge as a mathematical one. We live in our home countries, consume local news, and feel the immediate energy of local bull markets. If the Swedish stock market skyrockets, a Canadian investor likely won't feel the 'fear of missing out.' However, if the TSX is surging while a globally diversified portfolio lags behind, the temptation to abandon a long-term strategy and 'buy high' into the local market becomes overwhelming.
Maintaining a moderate home bias serves as a behavioral safety valve. By holding a meaningful amount of domestic equity, investors ensure their portfolios keep pace with the market they see on the news every day. This alignment reduces the risk of performance chasing and helps investors stay the course during periods when their home market is the global leader. While currency exposure is often cited as a reason for home bias, it is generally a secondary factor; the psychological benefit of local participation is far more impactful.
Finding the Middle Ground
There is no single, objectively 'correct' geographic allocation that applies to everyone. The decision requires balancing the undeniable benefits of global diversification against the practical advantages of domestic investing, such as lower fees, better tax treatment, and behavioral stability. While a 3% allocation to Canada might be theoretically pure for a Canadian, it is likely sub-optimal when costs and volatility are factored in.
A sensible middle ground is often found in simplicity. Many modern asset allocation funds have moved toward a roughly equal split between domestic, U.S., and international developed markets. This approach acknowledges the trade-offs: it captures the lion's share of global growth while retaining enough domestic exposure to keep costs low and the investor's behavior in check. A little home country bias, it turns out, is not just a common habit—it is a rational component of a well-constructed portfolio.