Equity Home Bias

Diplomarbeit von Adam Hantak

Introduction:

Every investor faces the challenge of making the right investment decisions. Upon analysing the allocation of wealth among countries, it becomes evident that investors do not invest their financial wealth internationally, but tend to invest the majority of their wealth in domestic equity. Financial theory deems this behaviour irrational, since holding a domestic portfolio is considered to be suboptimal due to the foregone benefits of international diversification.

Assuming that the financial theory is right in this prediction, the question as to what are the causes for this irrational behaviour comes to mind and forms the focal point of this work.

One the one hand, investors may be well aware of the costs connected with holding a domestic portfolio. Market restrictions, however, do not allow investors to attain the optimal international portfolio. On the other hand, investors may be unaware of the benefits of international diversification, and instead have a preference for domestic equity and fail to perceive the domestic portfolio as suboptimal. The traditional financial theory for this behaviour provides the institutional explanations with the focus on market imperfections and the behavioural financial theory provides explanations with the focus on investor irrationality. Following this classification of both theories, this work briefly reviews institutional explanations, as many of them lack empirical evidence and concentrates mainly on the behavioural explanations, as they are the focal point of current research and find wide empirical support.

After defining equity home bias and related concepts in Chapter 2, the costs of equity home bias are discussed in Chapter 3. In Chapter 4, institutional explanations are considered. Section 4.1 reviews briefly a number of older institutional explanations, such as direct investment barriers, transactions costs and taxes, as they do not find much empirical support. Section 4.2 explores in more detail an explanation based on information asymmetry, as it may at least partially contribute to the solution of the home bias problem.

With the emergence and acceptance of behavioural finance new explanations based on irrationality of investors were advanced and are presented in Chapter 5. Section 5.1 explores optimistic expectations about domestic markets as one of the early behavioural explanations. Section 5.2 deals with the competence hypothesis and creates a foundation for the familiarity hypothesis. Through the concept of equity familiarity, section 5.3 shows, how one can determine the characteristics of which equity is likely to be held internationally and domestically. Section 5.4 describes investor characteristics that may affect the probability of holding foreign or domestic equity. Chapter 6 presents the conclusions derived from the preceding chapters.

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Chapter 5, Behavioural explanations of equity home bias:

Due to the assumed investor rationality with the traditional theory, asset prices always incorporate all fundamental information available and mirror the true, fundamental asset value. If irrational investors cause a change in the ‘true’, efficient asset price through their market behaviour, rational investors immediately arbitrage away this mispricing and yield a profit at the expense of irrational investors. The corollary is that irrational investors must leave the market and the efficient prices prevail.

Behavioural financial theory questions these basic assumptions of investor rationality and power of arbitrage. According to the behavioural theory investors are not rational, but driven by various cognitive and emotional biases. Even if a group of rational investors were to exist, the limited arbitrage mechanism cannot secure efficient prices.

In the domain of equity home bias, the dominant behavioural argument is investor irrationality. Various behavioural biases are responsible for the suboptimal decision of home biased portfolios. Investors have overly optimistic expectations about the domestic market and consider themselves to be more competent about familiar, domestic equity. Furthermore, different investor characteristics influence the equity home bias. These are examined more closely in this chapter.

5.1, Optimistic expectations for the domestic market:

In accordance with the traditional theory, French and Poterba compute the implicit expectations for international markets, which predict the actual holdings of domestic and foreign equities of six leading economic countries. Surprisingly, they find that expected returns varied not only across countries for a given investor, but even for the same market across investors (Table 1). To build expectations according to nationality is irrational.

US, Japanese and British investors expect the highest return on their domestic market. This result does not change even if using an alternative benchmark, the international, value-weighted portfolio. Domestic investors would still need to expect higher returns on the own market than the imputed expected returns from the value weighted-portfolio, to explain the observed equity holdings. The imputed optimism towards home equity and pessimism towards foreign equity may be the cause of the home bias.

Shiller, Kon-Ya and Tsutsui find such discrepancies in expectations among US and Japanese institutional investors. From survey sent biannually to a large number of leading Japanese and US financial institutions over the period 1989 ‑ 1994, responses to questions concerning various topics were collated. Survey participants were asked to assess the development of Japanese Nikkei 225 and of the US Dow Jones Industrial Average in three, six, twelve months and ten years' time.

In the majority of cases Japanese investors expected about 20 percentage points higher annual returns on the Japanese market than the American investors (Table 2) and in no single case did this spread in expectation fall below 10 percentage points. Although Japanese investors were overall more optimistic than their American counterparts, the spread in expectations on the US market was not as great as the spread on the Japanese market. French and Poterba coin the term ‘relative optimism’, meaning that the spread in expectations between domestic and foreign investors is higher for the domestic market than for foreign markets.8 One could think of relative optimism in the following way: when investors from different countries assess the expected returns of all markets, the positive divergence of expected return on a given country across all investors from the average expected return on that country would be the greatest for the domestic investors.