International Diversification and Labor Income Risk

Home bias in international macroeconomics refers to the fact that investors around the world tend to allocate majority of their portfolios into domestic assets, despite the potential benefits to be had from international diversification. This phenomenon has been occurring across countries, over time, and across equity or bond portfolios. The bias towards domestic assets tends to be larger in developing countries relative to developed economies, with Europe characterized by the lowest equity home bias, while Central and South America—by the highest equity home bias. In addition, despite the secular decline in the level of equity home bias over time in all countries and regions, home bias still remains a robust feature of the data. Whether home bias is a puzzle depends on the portfolio allocation that one uses as a theoretical benchmark. For instance, home bias in equity portfolio is a puzzle when assessed through the lens of a simple international capital asset pricing model (CAPM) with homogeneous investors. This model predicts that investors should hold world market portfolios, namely a portfolio with the share of domestic asset equal to the share of those assets in the world market portfolio. For instance, since the share of US equity in the world capitalization in 2016 was 56%, then US investors should allocate 56% of their equity portfolio into local assets, while investing the remaining 44% into foreign equities. Instead, foreign equity comprised just 23% of US equity portfolio in 2016, hence the equity home bias. Alternative portfolio benchmark comes from the theories that emphasize costs for trading assets in international financial markets. These include transaction and information costs, differential tax treatments, and more broadly, differences in institutional environments. This research, however, has so far been unable to reach a consensus on the explanatory power of such costs. Yet another theory argues that equity home bias can arise due to the hedging properties of local equity. In particular, local equity can provide insurance from real exchange rate risk and non-tradable income risk (such as labor income risk), and thus a preference towards home equities is not a puzzle, but rather an optimal response to such risks. These theories, main advances and results in the macroeconomic literature on home bias are discussed in this article. It starts by presenting some empirical facts on the extent and dynamics of equity home bias in developed and developing countries. It is then shown how home bias can arise as an equilibrium outcome of the hedging demand in the model with real exchange rate and non-tradable labor income risk. Since solving models with portfolio choice is challenging, the recent advances in solving such models are also outlined in this article. Integrating the portfolio dynamics into models that can generate realistic asset price and exchange rate dynamics remains a fruitful avenue for future research. A discussion of additional open questions in this research agenda and suggestions for further readings are also provided.

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Relationship between Labor‐Income Risk and Average Return: Empirical Evidence from the Japanese Stock Market

The Journal of Business ◽

10.1086/209747 ◽

1998 ◽

Vol 71 (3) ◽

pp. 319-347 ◽

Cited By ~ 78

Author(s):

Ravi Jagannathan ◽

Keiichi Kubota ◽

Hitoshi Takehara

Keyword(s):

Stock Market ◽

Empirical Evidence ◽

Labor Income ◽

Income Risk ◽

Labor Income Risk ◽

Average Return ◽

Japanese Stock Market

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Labor Income Risk and Car Insurance in the UK

The Geneva Papers on Risk and Insurance Theory ◽

10.1023/b:gepa.0000032566.45964.21 ◽

2004 ◽

Vol 29 (1) ◽

pp. 55-74 ◽

Cited By ~ 5

Author(s):

Winfried Koeniger

Keyword(s):

Labor Income ◽

Income Risk ◽

Labor Income Risk ◽

Car Insurance ◽

The Uk

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Labor income risk and households’ risky asset holdings

Studies in Economics and Finance ◽

10.1108/sef-09-2014-0168 ◽

2016 ◽

Vol 33 (2) ◽

pp. 262-280 ◽

Cited By ~ 2

Author(s):

Gideon Becker ◽

Thomas Dimpfl

Keyword(s):

Unobserved Heterogeneity ◽

Investment Decision ◽

Labor Income ◽

Income Risk ◽

Cross Sectional ◽

Financial Situation ◽

Content Type ◽

Labor Income Risk ◽

Cross Sectional Dimension ◽

The Impact

Purpose Financial theory suggests that with increasing labor income risk, the reluctance of households to hold stocks increases. Therefore, this paper aims to investigate the determinants of a household’s decision on whether to invest in risky financial assets. Design/methodology/approach Income risk is measured as the observed variation of household income over a five-year period. The authors use both the time and the cross-sectional dimension of the German socio-economic panel to control for unobserved heterogeneity. Findings The authors find that indeed higher variation, i.e. higher income risk, reduces the propensity to invest in risky assets. However, when controlling for household heterogeneity, as well as subjective measures of a household’s financial situation (income satisfaction, worries about financial situation), the impact of observed labor income variation vanishes. It is therefore concluded that in particular the perception of investment risk and of the riskiness of the environment determines the investment decision to a great extent. Originality/value The paper contributes to a better understanding of a household’s investment decision-making process. To the best of the authors’ knowledge, it is the first to fully exploit the panel structure of the data to control for unobserved heterogeneity which leads to novel conclusions with respect to the effect of labor income.

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