Non-Equity Risks and Equity Home Bias

Abstract

A long literature focuses on equity risks only to conclude that the benefits in holding foreign stocks are substantial, and investors in practice allocate a much too heavy weight of their portfolios to domestic securities. We re-examine this conclusion by using a consumption-based approach, which can take the effects of nontraded wealth into account, even when its returns are not observable. Although there are significant benefits from further international consumption risk sharing, these benefits are not attainable using international equities as instruments. These findings are consistent with the ideas of Shiller (1993, 2003) and Athanasoulis and Shiller (2001), who argue that the world's largest macroeconomic risks cannot be effectively shared using existing securities.

Keywords: Equity home bias; International risk sharing; Non-equity risks; Euler equations; Consumption-based models

JEL Classification: F41, G11, G15