Equity Home Bias (PDF)

Inhaltsangabe: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 [...]