Investor home bias prevails in markets around the world. So says a 1997 IMF survey of cross-border equity holdings in 29 countries, the first study that applied econometric cross-sectional analysis to bilateral portfolio holdings within a large sample of countries.
A 2004 IMF working paper compared the original survey’s observed percentages of domestic equity holdings with an optimal percentage predicted by the Capital Asset Pricing Model (CAPM).
There are valid reasons to deviate from CAPM-implied weights, but the survey provides a point of comparison. The authors consider the difference between actual weights and CAPM weights to be a descriptive measure of home bias. The numbers are striking.
In another paper, “Investor Diversification and International Equity Markets,” Kenneth French and James Poterba conclude, “non-trivial risk reduction is available from cross-border holdings.”
They also ask what set of expected returns would explain each country’s observed pattern of domestic holdings versus that of a value-weight strategy. They found home bias among U.S., Japanese, and U.K. investors implied higher return expectations of 90, 250, and 400 basis points in their respective home markets.
Also, an investor’s human capital is likely far more correlated with domestic than international markets, so the diversification benefits of investing globally are even more pronounced in total wealth. Despite this, the authors contend investors hold nearly all their wealth in domestic assets.
Literature has failed to develop a generally accepted explanation. Possible causes often cited include institutional constraints (e.g., the now-abolished foreign content limit in Canada), as well as taxes and higher transaction costs.
French and Poterba note while transaction costs may be higher in some markets, these cost differentials should lead investors to the most liquid markets, not their own domestic markets. Further, since all shares must be owned by someone (i.e., there are no orphaned stocks), differences in transaction costs should be reflected in variations in expected returns.
Recently, the home bias debate has pitted local investors’ informational advantage against behavioural issues. Investors tend to regard the potential performance of their own markets more optimistically. The French and Poterba paper documented that phenomenon, also known as relative return optimism, but this effect is also evident in research on market expectations of fund managers, as well as behavioural studies.
Information asymmetry is another behaviour-related explanation. It proposes an investor’s perception of informational advantage contributes to home bias, even though being close to the source offers no real benefit. Similar to relative return optimism, even sophisticated investors believe in the advantage of information asymmetry. A survey of fund managers in Germany by Torben Luetje and Lukas Menkhoff revealed the more they believe they’re better informed than foreign investors, the more they invest in domestic assets. Yet, these managers neither forecast home stock market developments better, nor rely on data sources that are only available locally.
New developments and data suggest a general reduction in equity home bias. Plausible explanations include globalization, free trade growth, the Internet, the rise of emerging markets, and increased mutual fund investment.
Some advisors structure portfolios to benefit from global diversification. Yet diversification neither assures a profit nor eliminates the risk of market loss. Two reasons for their partial immunity to home bias are:
- A solid grounding in modern finance; and
- An equilibrium view of markets.
Modern portfolio theory helps advisors recognize the benefits of diversification. Also, a belief in the efficiency of capital markets offsets the perception of information asymmetry that traps investors into high allocations of domestic securities.
There is more information in the price of a security than anyone possesses individually, regardless of where they reside. With an equilibrium view, you don’t care how much information you have about foreign securities. Instead, you care about how much information all market participants collectively have.