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Sunday, February 26, 2012

The persistence of Home Bias (explained)


Every time I teach international portfolio theory to my students I have to face the inevitable question.

Diversifying one's portfolio --> good.
International diversification --> Much better

If it is so good to diversify abroad... then why don't people do it?
well... This is Home Bias, or the tendency of investors to hold a disproportionate amount of shares from their own home country.
The chart below will serve for illustration (figures as of 2010):


The US stock market represents almost 30% of the world's stock market. (Down from 40% in 2005) A rational American investor should have 30% of her money in American stocks. A French investor should have only 3.55% of his money in French companies and the rest spread through the world. In reality investors hold most of their portfolio in companies in their own countries.
The next chart shows that Germans hold almost 50% of their portfolio in German stocks.  If they were rational, they should hold no more than 3%.



To make matters worse, another 35% is Eurozone + UK




This is not rational. Investors are leaving money on the table. It is a puzzle.

The answers to this puzzle go from
Capital immobility... Investors can not move their money freely across countries... (taxes and other restrictions) to Information immobility... foreigners have better information about their own countries, How can an American investor make sense of the French or Chilean markets. A third explanations refers to Consumption hedging; Mexican investors invest in Mexico because they consume (now and in the future) in Mexican Pesos. Mexican companies provide a natural hedge against currency fluctuations which can be very wide and have profound implications. See my blog on Brazil versus Mexico.

There is a great video by Ken French from Tuck further explaining the topic.


I am an optimistic. A recent article in the Financial Times shows that in 1980 Americans held 2% of their portfolio overseas by 2007 it was 27%. This is a dramatic improvement.

2 comments:

  1. This is interesting and I have heard of home bias from an investments course with Goolgashian. However, Im curious why the portfolio should represent percentages resembling total market capitalization. You can have high returns and be 100% in US as long as you are tracking the right ETF or companies. I understand interest rates as well as inflation as well as political agendas can oftentimes have impact on the market as a whole, but I dont see why I would only have 5.8% of my portfolio in China since that is its market cap. If anything I would have a higher percentage allocated to an emerging economy if there are promising and more attractive returns. Interesting point.

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