Sub-optimal international portfolio allocations and the cost of capital

• Domestic investors in emerging countries overinvest in their local stock markets.
• Foreign investors prefer developed stock markets in equity portfolio allocation.
• Developed markets experience a lower cost of capital relative to emerging markets.
• Higher prevalence of home bias in a country leads to a higher cost of capital.
• Countries that experience higher foreign bias enjoy a lower cost of capital.

Finance theory suggests that the optimal international equity portfolio investment by home and foreign investors reduces the cost of capital through international risk sharing and capital market integration. However, the empirical evidence is inconsistent with theory as a number of studies show investors exhibit cross-country biases in their international portfolio investments, known as home and foreign biases. In this study we investigate the implications of home and foreign biases on the cost of capital. Using data from 44 countries over the period 2001–2014, we provide strong evidence that countries that experience higher home bias are associated with a higher cost of capital. Similarly, we also find that countries that are more favoured by foreign investors, relative to the theoretical predictions, are associated with a lower cost of capital.