Human capital and international portfolio diversification: a reappraisal

We study the implications of human capital hedging for international portfolio choice. First, we document that, at the household level, the degree of home country bias in equity holdings is increasing in the labor income to financial wealth ratio. We show that a heterogeneous agent model in which households face short selling constraints and labor income risk, calibrated to match both micro and macro labor income and asset returns data, can both rationalize this finding and generate a large aggregate home country bias in portfolio holdings. Second, we find that the empirical evidence supporting the belief that the human capital hedging motive should skew domestic portfolios toward foreign assets, is driven by an econometric misspecification rejected by the data. Third, we show that, given the high degree of international GDP correlations in the data, very small domestic redistributive shocks are sufficient to skew portfolios toward domestic assets.