Puzzle No.

3
Equity Home Bias in Portfolios
Equity Home Bias term was first used by French and Poterba (1991) in their paper “International

Diversification and International Equity Markets”. It explains that investors hold disproportionate

amount of home equities relative to the world market portfolio despite of being aware of the

benefits of international diversification.

French and Poterba (1991) estimates showed very little percentage of foreign equities held by US

and Japan, 1.9% and 6.2% respectively, only. Factors creating home bias were categorized into

major categories i.e., institutional factors and behavioral factors. Institutional factors may play a

huge role in affecting the foreign return by limiting the hold of investors on foreign stocks.

However, it is not easy to identify these constraints. Institutional factors include taxes and

transaction costs. Foreign equity is expected to have high taxes on them then domestic equities

which shift the investors’ behavior towards more of domestic equities. However, there is not much

difference between the taxes and this fails to explain the home biasness.

Another reason suggested was the explicit limits imposed by the governments on holding foreign

equities but these were also not binding. Hence, the major reason of home biasness was investor

choices that despite of having fewer tax differences and constraints, they still want to hold home

based equities.

Behavioral factors also play an important role in creating equity home bias. When estimating risks,

investors associate more risk to foreign equities based on their less knowledge of foreign markets.

Also, they expect the returns on domestic equities to be higher than returns in international equity

markets.
Sercu and Vanpee (2007) argued that equity home bias occurs due to imperfect diversification of

portfolios. Equity home bias becomes a puzzle when risk reduction are foregone by not investing

in foreign investments to diversify portfolios. Sercu and Vanpee also explained equity home bias

puzzle in terms of five different theories.

1. Foreign Investment Costs

Transaction costs, difference in tax and all other types of implicit and explicit costs may

have a role in creating equity home bias.

Model associated with costs have been proposed by Stulz(1981) and Errunza and Losq

(1985) and were used to identify the size of costs in explaining equity home bias. In this

category Cooper and Kaplanis (1986) analyzed the pricing but they did not consider the

welfare affects in investment obstacles (capital flow controls). Later on Errunza & Losq,

(1989) discussed the effect of capital flow controls on both securities pricing and welfare

effect of investment barriers or restrictions. They concluded that ejections of barriers leads

to enhance the aggregate market value of securities and therefore markets will be more

integrated. Moreover they highlighted that welfare of investors increases by instigating

various types of index fund in global market.

Stulz and Wasserfallen (1995) did a study on Swiss market and found that foreign stocks

have downward sloping demand curve because these stocks are restricted and this increases

the price of stocks available to foreign investors. When restrictions on stocks are lifted,

price of unrestricted stocks increases and of that unrestricted stocks decreases. These

restrictions on stocks are not imposed by the government but are rather imposed by the

companies.
Martin and Rey (2004) developed a model which showed that as transaction costs

increases, the demand for foreign assets decreases. Banking fees, information collecting

costs and exchange rate costs are forms of transaction costs. Theoretically they showed that

equity home bias is created from transaction costs.

Taxes is the third type of costs that results in equity home bias and it has been tested by

Mishra and Ratti (2012). They found that high tax rates creates equity home bias if the tax

is not offset by tax credits. When taxes are offset by providing tax credits on dividends then

it reduces equity home bias.

Fama and Schwert (1977) demonstrated that stocks are not associated with labor income

at macro level therefore expected returns are effective in explaining home bias .They

incorporated extra costs in the model such as additional taxes for holding foreign equities

and it gives inference of both asset pricing and holding the international portfolio.

While analyzing the equity portfolio home bias puzzle, agency costs have been

incorporated into model by Stulz (2005).He used simple one‐period partial equilibrium

model and he takes into account new firms. He analyzed only all‐equity public firms in

which each share has one vote and analyze only portfolio equity flows. He predicted that

when the twin agency problems are important then foreign direct investment represents a

greater fraction of capital flows. Further he pointed out that Co‐investment restricts the

gains from financial globalization because it makes difficult for risks to be shared

internationally .It has following implications such as insiders of corporate have to bear risk

of the firms. Wealth of the corporate insider is the constraint in size of the firm. Co‐

investment drives the corporate insiders to have massive amount of their firms' equity in
 their portfolios because lower risks can be shared globally. Co‐investment reduces the

effect of a decrease in the cost of equity capital on firm investment.

Besides these he also forecasted various other aspects of corporate finance such as the

economies having more twin agency problems are expected to have more proportion of

short term debt and more leverage. He concluded that for more financial globalization,

agency problems should be controlled.

In explaining the puzzle, Sercu and Vanp´ee (2008) demonstrated that implied costs for

investments into emerging markets are much higher than for developed economies. There

exists a great difference with direct cash costs in both types of economies.

2. Domestic Risk Hedging

Domestic assets are preferred due to known risk associated with them e.g., inflation risk,

consumption risk, real exchange rate risk and non-tradeable wealth risk. Obstfeld and

Rogoff, (2000) provided better explanations of the home bias caused by hedging demands

where by local equities hedge the consumption risk of non-traded goods. According to

Obstfeld and Rogoff, trade costs are important determinant of home bias. Model used by

them had imperfections which made home bias frictions in goods markets rather than

capital market imperfections.

In the recent literature Glassman and Riddick (2001) pointed out possible reasons for home

bias. However they focused on risk associated with holding foreign assets and excluded

assets that affect correlations. He concluded that asset returns remain inconclusive.
3. Asymmetric information

It is expected to play a major role in creating equity home bias because investors would

want to invest in the portfolio regrading which they have most of the information and

usually investors have more information about domestic portfolios rather than foreign

which led them to having more of domestic equities. Sarkissian and Schill (2004) used

regression analysis to capture the impact of asymmetric information on foreign investment

choices using geographical, cultural and economic differences between the countries and

found significant results.

According to Coval et al (1999) geographical proximity or distance is one of the important

factor in explaining the portfolio choice. They also introduce various characteristics of

firms such as they tend to have small domestic holdings, non-trading goods producing with

high financial leverage. Their findings indicate that information asymmetries might driving

the preference for geographical proximities.

(Grinblatt and Keloharju, 2001) proposed that asymmetries are also in the form of

translation costs. This includes the cost of translating and interpreting foreign news articles

and balance sheet information, costs of adapting to new cultures and norms or

transportation costs.

Van et al (2009) studied a criticism of information‐based models of the home bias. They

proposed new model related to information. And they argued that investors have more

gains from knowing information others do not know. Investors learn more about risks they

have an advantage in because they want their information to be different than the others.

They combine the observed features of assets to predictions about investors' information

sets. Their main focus was that information asymmetry assumptions are reasonable and
 small initial information advantages can proceed to a home bias. He argued that

information cannot be observed while it can be forecasted. So they contributed in

explaining home bias puzzle by a new way to bring information‐based theories to the

existing theories.

They critiqued information-based models of home bias and argued that rational expectation

is the main cause of equity home bias among investors. If less information is available to

the home investors then why would they not try to acquire that information and reduce

home bias? The answer to this question is that investors willingly do not try to learn that

information hence enforcing information asymmetries. They learn more about the risk in

which they have more advantage due to the fact that they want their knowledge to be

different from the others. Hence asymmetric information among investors is by choice and

not by chance.

4. Governance

Low governance and political instability is a driver in creating information asymmetries

hence creating equity home bias. It has been found by Leuz et al (2010) that countries with

more political risks and less protection structures available to the foreign investors can

cause governance problems which restricts the foreign investors to invest in such a country.

Stulz (2005) highlighted the second agency problem according to which other than the

conflicts of interest existing between corporate and foreign investors, there is an agency

problem of state-ruler discretion. This problem arises when state rulers take actions to

improve their own welfare at the cost of investors. He showed both theoretically and
 empirically that these two problems are positively correlated. Moreover, this twin agency

problem impact international portfolio holdings in three ways:

i. Countries with poor governance have a smaller fraction of wealth owned by foreign

investors because these countries have important proportion of large, controlling

shareholders.

ii. Smaller countries have a larger fraction of wealth owned by foreigners, and

investors who live in countries with a small share of the world market portfolio

invest more abroad

iii. Countries with a high risk of state expropriation have a lower fraction of wealth

owned by foreign investors, all else equal.

Hence to reduce equity home bias in countries with weak governance it is essential to safeguard

the rights of minorities by developing strong institutions.

5. Investors Behavior

Vanguard summarize four different factors regarding investors’ behavior which promotes

equity home bias and these are as follows:

 Investors’ expectation regarding future returns are higher in their home markets as

compared to foreign markets.

 Investors favor choosing something that they are familiar with or in other words

they favor the “known devil”. Investors are familiar with home markets and it

becomes difficult for them to get out of their comfort zones. Moreover, they are

familiar with the rules and regulations of their own governments as compared to

foreign governments.
  Investing in foreign markets is often considered risky by the investors due to

volatile exchange rate. It becomes one of the major factor in creating home

biasness.

 A misconception, widely found among the investors that investing in a

multinational company located in home district will bring same returns as to

investing in the same multinational company located in another country creates

home biasness.

Similarly Lewis (1995) analyzed the two puzzles in international financial markets.

The first one focus under standard assumptions about rational expectations and second

is home bias puzzle. Lewis (1999) investigated the other possible hedging explanations,

such as hedging human capital. If home stocks would be better able to diversify away

the risk of labor income, the portfolio would rationally be home biased.

In the same vein, Bretscher (2016) manifested that human capital can assist in

rationalizing the home bias equity in both at individual and macro level .By using buffer

stock saving model they concluded that home bias arises as there is more labor income

risk associated with household level. Moreover the results of heterogeneous agent

model also reveal that the portfolio diversification decreases and the degree of home

country bias must increases at individual levels.

Similarly a survey by Cooper, et al (2013) emphasizes that the equity home bias probably occurs

due to multiple factors such as asymmetric information, capital flow controls and issues related to

governance and behavioral aspects. They also outlined some costs estimates related to under

diversification and argued that even though there are multiple factors yet the puzzle of home bias

remains unsolved.
By contributing in equity home bias literature Mishra (2015) investigated the several causes of

home bias. In his seminal paper he formulated different measures of home bias for 42 countries by

using various approaches such as the model based portfolio theory, international capital asset

pricing model (ICAPM) , data based mean-variance, minimum-variance, Bayes–Stein, Bayesian

etc. And he found that there is very slightly change in home bias measures using various models

for a few countries. He argued that foreign listing, idiosyncratic risk, natural resources rents, size,

global financial crisis and institutional quality have significant impact on home bias.

He elaborated that idiosyncratic risk (It is the risk which affects a very diminutive number of

assets, and can be almost eradicated through diversification. It is quite similar to unsystematic risk

it is particular to a small number of stocks) has a direct impact on home bias while foreign listing,

natural resources rents and institutional quality contributes in decreasing home bias. There is

uncertainty for trade having a negative impact on home bias. Their empirical findings have

significant implications such as Governments should encourage cross border trade in goods and

services that lead to improve cross border asset trade indirectly. Policy makers should adopt

various measures in order to improve natural resources rents, as these indirectly stimulate cross-

border investment. Similarly other policies like Stock market regulation policies should be devised

in such a way that boosts investment through foreign listing.

Opinion

Equity home bias puzzle has been unresolved despite of extensive studies and literature trying to

resolve this puzzle. Our analysis is that all the above mentioned factors are integrated and

contributing simultaneously in creating equity home bias. Of all the factors, investors’ behavior

are the most influential factor as it is not easier to predict human behavior regarding the choices

and preferences. Further analysis can be done centering behavioral aspects in resolving this puzzle.
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