Equity home bias puzzle

The Equity home bias puzzle is the term given to describe the fact that individuals and institutions in most countries hold modest amounts of foreign equity. This is puzzling since observed returns on national equity portfolios suggest substantial benefits from international diversification. The home bias in equities was first documented by French and Poterba (1991) [French, Kenneth and James Poterba (1991), "Investor Diversification and International Equity Markets," "American Economic Review: Papers and Proceedings" 81, 222{226.] and Tesar and Werner (1995) [Tesar, Linda and Ingrid Werner (1995), "Home Bias and High Turnover," "Journal of International Money and Finance" 14, 467-92.] .

Coval and Moskowitz (1999) showed that home bias is not limited to international portfolios, but that the preference for investing close to home also applies to portfolios of domestic stocks. Specifically, they showed that U.S. investment managers exhibit a strong preference for locally headquartered firms, particularly small, highly leveraged firms that produce nontradable goods. [Coval, J.D., and T.J. Moskowitz, 1999, "Home Bias at Home: Local Equity Preference in Domestic Portfolios" "Journal of Finance" 54, 2045–2074 .]

Maurice Obstfeld and Kenneth Rogoff identifies this as one of the six major puzzles in international macroeconomics.Citation | last= Obsfeld | first= Maurice | last2= Rogoff | first2= Kenneth | year= 2000| editor-last= Bernanke | editor-first= Ben | editor2-last= Rogoff | editor2-first= Kenneth | contribution= The Six Major Puzzles in International Macroeconomics: Is There a Common Cause? | title=NBER Macroeconomics Annual 2000 | volume = 15 | pages = 339-390 | publisher= The MIT Press | isbn = 0-262-02503-5] The others are the Feldstein-Horioka puzzle, the home bias in trade puzzle, the consumption correlations puzzle, the purchasing power and exchange rate disconnect puzzle, and the Baxter-Stockman neutrality of exchange rate regime puzzle.

Possible explanations

One hypothesis is that capital is internationally immobile across countries, yet this is hard to believe given the volume of international capital flows among countries.

Another hypothesis is that investors have superior access to information about local firms or economic conditions. But as van Nieuwerburgh and Veldkamp (2007) [Van Nieuwerburgh, Stijn and Laura Veldkamp (2007) "Information Immobility and the Home Bias Puzzle"] points out, this seems to replace the assumption of capital immobility with the equally implausible assumption of information immobility.

References