Equity home bias puzzle

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In finance and investing, the Home bias puzzle is the term given to describe the fact that individuals and institutions in most countries hold only modest amounts of foreign equity, and tend to strongly favor company stock from their home nation. This finding is regarded as puzzling, since ample evidence shows equity portfolios obtain substantial benefits from diversification into global stocks. Maurice Obstfeld and Kenneth Rogoff identified this as one of the six major puzzles in international macroeconomics. [1] [2]

Contents

Overview

Home bias in equities is a behavioral finance phenomenon and it was first studied in an academic context by Kenneth French and James M. Poterba (1991) [3] and Tesar and Werner (1995). [4]

Coval and Moskowitz (1999) showed that home bias is not limited to international portfolios, but that the preference for investing close to home also applies to portfolios of domestic stocks. Specifically, they showed that U.S. investment managers often exhibit a strong preference for locally headquartered firms, particularly small, highly leveraged firms that produce nontradable goods. [5]

Home bias also creates some less obvious problems for investors: by diminishing the cost of capital for companies it limits the shareholders' ability to influence management by threatening to walk out. It partly explains why foreign investors tend to be better at monitoring firms they invest into. [6]

The home bias, which was prevalent in the 1970s and 1980s, is still present in emerging market countries, but there are some recent data showing some support for the decline in the equity home bias in developed market countries. [7]

The benefit from holding a more equally diversified portfolio of domestic and foreign assets is a lower volatility portfolio. On average, US investors carried only 8% of their assets in foreign investments. [8] Historical data indicates that holding an entirely domestic US portfolio would result in lower volatility of returns than an entirely foreign portfolio. A study conducted by economist Karen Lewis found that a weight of 39% on foreign assets and 61% on domestic US assets produced the minimum volatility portfolio for investors. Foreign asset exposure has been on the rise in the past few years, however with the average US portfolio carrying 28% foreign assets in 2010 as opposed to just 12% in 2001. [9]

Attempts to resolve the puzzle

One hypothesis is that capital is internationally immobile across countries, yet this is hard to believe given the volume of international capital flows among countries.

Another hypothesis is that investors have superior access to information about local firms or economic conditions. But as van Nieuwerburgh and Laura Veldkamp (2005) [10] point out, this seems to replace the assumption of capital immobility with the assumption of information immobility. The effect of an increase in trade and the development of the Internet support the hypothesis about information immobility as well as information asymmetry. [11]

In some countries, like Belgium, holding stocks of foreign companies implies a double taxation on dividends, once in the country of the company and once in the country of the stockholder, while domestic stock dividends are taxed only once.[ citation needed ]

In addition, liability hedging and the perception of foreign exchange risk are other possible causes of the home bias. [12]

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Linda L. Tesar is a professor of economics and director of graduate studies at the University of Michigan College of Literature, Science, and the Arts (LSA), the liberal arts and sciences school of the University of Michigan in Ann Arbor. She is also a research associate at the National Bureau of Economic Research and the Editor-in-Chief of the IMF Economic Review. She has been a visitor in the Research Departments of the International Monetary Fund, the Federal Reserve Board of Governors and the Federal Reserve Bank of Minneapolis. In the past, she has also served on the academic advisory council to the Federal Reserve Bank of Chicago. From 2014 to 2015, Tesar served as Senior Economist on the Council of Economic Advisers.

References

  1. ↑ Obstfeld, Maurice; Rogoff, Kenneth (2000). "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?". In Bernanke, Ben; Rogoff, Kenneth (eds.). NBER Macroeconomics Annual 2000. Vol. 15. The MIT Press. pp. 339–390. ISBN   978-0-262-02503-4.
  2. ↑ The other puzzles identified by Obstfeld and Rogoff are the Feldstein–Horioka puzzle, the home bias in trade puzzle, the consumption correlations puzzle, the purchasing power and exchange rate disconnect puzzle, and the Baxter–Stockman neutrality of exchange rate regime puzzle.
  3. ↑ French, Kenneth; Poterba, James (1991). "Investor Diversification and International Equity Markets". American Economic Review. 81 (2): 222–226. JSTOR   2006858.
  4. ↑ Tesar, Linda; Werner, Ingrid (1995). "Home Bias and High Turnover" (PDF). Journal of International Money and Finance. 14 (4): 467–492. doi:10.1016/0261-5606(95)00023-8. S2CID   154764632.
  5. ↑ Coval, J. D.; Moskowitz, T. J. (1999). "Home Bias at Home: Local Equity Preference in Domestic Portfolios". Journal of Finance. 54 (6): 2045–2074. CiteSeerX   10.1.1.197.766 . doi:10.1111/0022-1082.00181. JSTOR   797987.
  6. ↑ Ferreira, M. A.; Matos, P. (2008). "The colors of investors' money: The role of institutional investors around the world". Journal of Financial Economics. 88 (3): 499–533. doi:10.1016/j.jfineco.2007.07.003.
  7. ↑ Coeurdacier, Nicolas; Rey, Hélène (2013). "Home Bias in Open Economy Financial Macroeconomics". Journal of Economic Literature . 51 (1): 63–115. CiteSeerX   10.1.1.706.4051 . doi:10.1257/jel.51.1.63. S2CID   54926472.
  8. ↑ Feenstra, Robert C., and Alan M. Taylor. International Macroeconomics. N.p.: n.p., n.d. Print. 243.
  9. ↑ Feenstra, Robert C., and Alan M. Taylor. International Macroeconomics. N.p.: n.p., n.d. Print. 243.
  10. ↑ Van Nieuwerburgh, Stijn; Veldkamp, Laura (July 2005). "Information Immobility and the Home Bias Puzzle". NYU Working Paper. FIN-04-026. SSRN   1294476.
  11. ↑ Amadi, Amir Andrew (2004-05-05). "Equity Home Bias: A Disappearing Phenomenon?". Rochester, NY: Social Science Research Network. SSRN   540662.{{cite journal}}: Cite journal requires |journal= (help)
  12. ↑ Philips, Christopher; Kinniry, Francis; Donaldson, Scott (June 2012). "The role of home bias in global asset allocation decision" (PDF). The Vanguard Group. Archived from the original (PDF) on 2016-05-04. Retrieved 2019-08-30.

Further reading

Sanchirico, Chris William (2015), "As American as Apple Inc.: International Tax and Ownership Nationality". Tax Law Review. 68 (2): 207-274.

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