Suggested causes for home bias include:
- holding domestic assets can protect domestic investors against domestic risks such as inflation or exchange-rate depreciation;
- the benefits of international diversification are small relative to the transaction costs involved in buying foreign assets;
- and information on domestic assets is of better quality than that on foreign assets.
The scale of the home bias
“Home bias” characterises an excessively high weight of domestic assets in portfolios, relative to what would be optimal, and therefore results in an excessively low weight of foreign assets.
Is it possible to find rational explanations of home bias?
There may be irrational explanations for home bias i.e. investors are not penalised by losses on domestic assets as much as by losses on foreign assets and they have a "patriotic" attitude etc. But there may also be rational explanations for home bias such as hedging domestic risks, small benefits of international diversification, and quality of information.
1. Hedging of domestic risks
Investors will hold large portfolios of domestic assets if these assets provide a better hedge against specific domestic risks than foreign assets do.
Holding euro-zone equities is unlikely to protect investors in the euro-zone against a depreciation of the euro. Indeed, this much is evident when comparing the European stock market with the
Certainly, this argument cannot apply to bonds since countries that experience an unexpected increase in inflation normally experience a rise in long-term interest rates, which generates losses for domestic investors – meaning that an internationally diversified bond portfolio would actually be preferable.
In the case of equities, one could think that this is an asset indexed to prices, which therefore provides a hedge against domestic inflation. However, in the case of
2. Small benefits from international diversification
The idea is that if the benefits of international diversification are smaller than the adjustment costs (transaction costs) incurred when buying foreign assets, investors will abstain from international diversification. If we take the example of euro-zone bond portfolios, one would see that diversification to the euro-zone as a whole in the period 1999-2012 reduces the return and the risk slightly, but in a very limited way.
3. Advantage in terms of information
It is an often-heard argument that the information available for investors is better for domestic assets than for foreign assets – largely because investors have better contacts with company management and their own government.
If this is true, this bias is likely to be far larger for small and mid-sized companies than for large companies that have better information resources. As a result, we should expect larger unexpected (news) shocks for small and mid-caps than for large-caps, and subsequently higher volatility in small and mid-cap indices. Indeed, this appears to be the case. The volatility of large-cap indices has been lower since 2003 than that of small and mid-cap indices.