A rational explanation for home country bias

Document Type

Article

Publication Date

1-1-2000

Abstract

While modern portfolio theory predicts that investors should diversify across international markets, corporate equity is essentially held by domestic investors. French and Poterba (1991) [French, K., Poterba, J., 1991. Investor diversification and international equity markets. American Economic Review 81, 222-226] suggest that in order for this bias to be justified, investors must hold optimistic expectations about their domestic markets and pessimistic expectations about their foreign markets. Tesar and Werner (1995) [Tesar, L.L., Werner, I.M., 1995. Home bias and high turnover. Journal of International Money and Finance 14, 467-492] find existing explanations for the home equity bias unsatisfactory and conclude that the issue poses a challenge for portfolio theory. We develop a model that incorporates both the foregone gains from diversification and the informational constraints of international investing, and shows that home equity bias is consistent with rational mean-variance portfolio choice. Specifically, we prove that the nature of estimation risk in international markets can be responsible for this phenomenon. We show that when the cross-market variability in the estimation errors of international markets' means far exceeds the cross-market variability in the means themselves, domestic dedication dominates international diversification. An examination of 11 international markets' returns over the last 25 years, from the perspective of German, Japanese and US investors provides evidence consistent with this explanation. © 2000 Published by Elsevier Science Ltd. All rights reserved.

Identifier

0034196502 (Scopus)

Publication Title

Journal of International Money and Finance

External Full Text Location

https://doi.org/10.1016/S0261-5606(00)00007-3

ISSN

02615606

First Page

331

Last Page

361

Issue

3

Volume

19

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