Home Bias Puzzle the Home

Home Bias Puzzle The home bias in investing is defined as the tendency of investors toward domestic equities -- or even equities from their immediate geographic region. The puzzle aspect of home bias is that empirical evidence has supported broader geographic diversification as a means to lower risk and increase returns (Coval & Moskowitz, 1999). The explanations offered up for the bias have generally caused academics fits, yet they are perfectly reasonable in the real world. The first explanation for home bias is that international investing is more expensive and time-consuming.

Governments have restrictions on foreign stock ownership, transaction fees are higher, and the potential for foreign taxes all create barriers to foreign investment (Coval & Moskowitz, 1999). Outside of institutional investing, these restrictions remain real. However, even retail customers can circumvent these boundaries with international equity funds. While it has been argued that boundaries with regards to capital flows have been reduced, these do not impact the retail investor. Investing overseas requires working with a broker who is licensed to operate in that jurisdiction.

This can be a costly and time-consuming process, which renders such trading the dominion of institution investors. Home bias remains with that category of investor as well. The second set of explanations for home bias lies with information. It has been postulated that in today's information age, all investors should have equal access to information about a company. This argument rings hollow for several reasons.

The first is that information from other jurisdictions does not necessarily conform to a format familiar to American investors, with regards to financial statements, terminology or the types of information released. Investors have an inherent disadvantage in gathering information on companies that do not conform to the reporting requirements with which the investor is familiar. The second is that the information may not be in the investor's language or currency, resulting in translation error risk.

An American investor seeking information on a Japanese company will invariably uncover less useful data than a Japanese investor, strictly due to the language barrier. The third reason that information is not equal is that investors typically have specific insight into the geographies and industries of their nation or region. Those companies are the topic of conversation, they are visible, and investors have greater access to people within that company (not necessarily outsiders, just people who have minor insights that can be valuable).

Regional centers of knowledge are evident in global capital markets. For example, the Toronto Stock Exchange specializes in mining issues. While any investor around the world can research annual reports and news clippings about mining companies, in Toronto they are the subject of conversation within the community and the industry players right down to the manager level are known to investors. This gives Toronto investors a competitive advantage in mining investing, which will be reflected in a home bias.

As Van Nieuwerburgh & Veldkamp (2007) explain, home investors have a bias because they have information that non-home investors do not have. These information asymmetries persist, even with today's global information pipelines. The cost of information can be quite high, despite the relatively rapidity of its diffusion among global investors. There are other potential explanations. Campbell and Kraussl (2007) posited that international investing carries with it the perception of increased downside risk. This can come from time zone differences, speed of information diffusion or translation issues in non-English-speaking markets.

Whatever the concern, it is reasonable that international investing suffers as a result of increased perceived risk, even if that perception is not born out by reality. Another possible explanation is that investors are irrational. While the rational investor may understand that international diversification is valuable, an irrational investor may not care. It is important to remember that the rational investor is a construct of economic academia. In the real world, investors can be highly irrational, as evidenced by multiple bubbles and panics in the past dozen years.

It is likely that home bias is a puzzle in part because investors are expected to be rational when they are not, but also as a result of the other theories as well. Ahearne, Griever and Warnock (2004) showed that foreign firms with U.S. listings tend to receive due weighting in U.S. equity portfolios. Those that do not have U.S. listings are severely underweighted. This reflects both.