The Home Bias in Equity International Finance Puzzle

The home bias in portfolio puzzle refers to the concept that home investors prefer to hold home equities. Most economic models assume that investors take advantage of risk sharing and potential gains in returns provided by international capital markets. But empirical studies show that investors don’t optimally diversify internationally, and they favor their home country’s equity to the extent of holding almost all their wealth in domestic assets.

The question is why domestic investors don’t make use of potential gains from foreign investment opportunities. This question is especially puzzling when you consider the rapidly growing international capital markets.

Consider an example that demonstrates why having portfolios consisting of mostly domestic equities is puzzling. Remember the home bias in trade puzzle, which implies a much larger share of country trade in consumption. You know about various trade costs associated with goods trade. But what about international trade in equities?

Suppose that every country has equities issued by firms in the traded and nontraded goods sectors. In theory, trading equities between countries should happen without frictions. Now suppose that there’s no money in the world, and when you hold equities, you’re paid in goods that you consume.

Therefore, if you hold an equity (related to firms producing traded or nontraded goods at home or abroad), you’re paid in some particular good. In terms of domestic equities, under normal circumstances, the distinction between traded and nontraded goods doesn’t matter to you. If you receive your dividends in terms of haircut coupons, you can redeem them in your country.

But if you’re holding foreign equities, you need to hold the equity associated with the traded good. If you get paid in nontraded goods like haircuts, getting haircuts in a foreign country will be prohibitively expensive (with that airline ticket and all).

Therefore, depending on the share of nontraded goods in home and foreign output, one may expect some representation of foreign equity in domestic portfolios. But the observed domestic equity shares of 80 to 90 percent aren’t consistent with optimal portfolio diversification.

Some explanations of this puzzle are based on trade costs, which also include market inefficiencies such as asymmetric information and legal restrictions as a type of trade cost. But these explanations may apply more to developing countries that implement restrictions on capital flows and foreign ownership of domestic assets than to developed countries.

Therefore, the question is why there is a bias for home equity even in developed countries. Given the fact that international equity transactions aren’t significantly restricted in developed countries, one would not expect a strong home bias in equity holdings of developed countries.

But some studies suggest that potential benefits from investing in foreign equities must be compared to the transaction costs of acquiring these equities. Although transactions costs may be small with fully integrated capital markets, they must be compared with the potential gains from diversification.

Another explanation is that the market is inefficient and investors don’t recognize the potential gains from including foreign equity in their portfolio. Additionally, some studies suggest that domestic investors are overly optimistic about the returns on domestic equities.

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