Home Sweet Home Bias

Standard finance theory says to invest in lots of different things to reduce the correlation between their returns, and so reduce the variation in your return.  But people seem reluctant to invest outside their own nation.   A Journal of Banking and Finance article finds "the likelihood of home bias is caused by both rational and irrational factors."

We identify the type of individual with the highest likelihood of home bias as an older, unmarried, poorly educated man working for the government, who invests only a small amount of money, and who has no experience with risky investments outside the pension plan. … we find less sophisticated individuals to be relatively more home-biased. Moreover, our results are consistent with government employees, having a relatively high job security, and caring more about hedging domestic inflation than about international diversification, thus, having a bias towards domestic assets. Finally, as men are regarded as relatively more overconfident than women with respect to investments, they will have a relatively greater tendency for a perceived information advantage of domestic assets than women, and thus be more likely to overweigh their portfolios with domestic assets.  Hence, we can describe our home-biased candidate as a not so sophisticated man, who has a high level of job security, and seems to be somewhat overconfident.

It can make sense to invest more in assets correlated with prices in your region, if you expect to stay where you are.  But the typical home bias is larger than this can account for; it seems our anti-foreign bias strikes again.

P.S. The latest Journal of Banking and Finance says:

In 1908, Vinzenz Bronzin, … published a booklet … Like Bachelier’s now famous dissertation (1900) … the work seems to have been forgotten shortly after it was published. However, almost every element of modern option pricing can be found in Bronzin’s book. In particular, he uses the normal distribution to derive a pricing equation which comes surprisingly close to the Black-Scholes-Merton formula.

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  • http://profile.typekey.com/CatoRenasci/ Cato Renasci

    It seems to me that at least in terms of investment, much “anti-foreign bias” is quite rational: while a reasonably well-informed investor with risk profile X can rationally assess the risks in a particular investment in his ‘home’ region (which I would define as a region in which expectations about legal risks, information reporting format, sovereign risk, taxation, and currency risk is more or less homogeneous), it requires considerably more effort to assess risks of a particular investment in a region with different legal structure governing contracts, different information reporting and accounting requirements, different taxation schemes, and with different amounts of sovereign risk and currency risk.

    Unless the anticipated return from the foreign investment were sufficiently greater than that for a ‘home’ investment to exceed the cost of obtaining the knowledge necessary to assess such risks as effectively as one can assess risks at ‘home’ and to maintain both that knowledge and the knowledge to assess ‘home’ risks, then it seems to me perfectly rational for an investor to prefer ‘home’ investments.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Cato, we are not talking about making bets on particular investments, we are talking about investing in broad aggregates in order to reduce risk. Most people don’t know enough to make wise bets on anything, at home or abroad.

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    One source of the home bias is that most people are not aware that they are
    losing by not investing abroad when they fail to do so. If they do not travel,
    they do not observe the changing exchange rates, or if they observe a devaluation
    of their own currency, it may be in an obscure way, such as higher prices at
    Wal Mart.

    Of course, the normal distribution is not the accurate one for fin market returns.
    They show leptokurtosis by and large, and so the Black-Scholes-Merton formula needs
    considerable modifying, which practitioners are well aware of.

  • http://profile.typekey.com/tschoegl/ Adrian Tschoegl

    Re Bachelier and Bronzin: If a tree falls in the forest with no one there to hear it, does it make a sound?

    The cases of Bachelier and Bronzin point to an interesting problem in judging quality of research in academia. If a work is not highly cited, ie, if it is not part of a coversation, is it good, even if the failure to start a conversation is a failing of their colleagues, not a failing of their work?

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Adrian, your question is deep and important. I do think that if blame lies with colleagues for not appreciating the work, and if they could not reasonably anticipate such lack of appreciation, then we should judge their work as good. The harder question is what if they could reasonably anticipate such unfair neglect of their work?

  • Douglas Knight

    reasonably anticipate such unfair neglect of their work

    In practice, most people live to observe the unfair neglect of their work. If they understood the importance of it, they should have promoted it a decade later.

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    Douglas,

    One can “promote” all one wants, but that does not guarantee that one achieves
    recognition (or gets cited sufficiently, to note the boring academic aspect of this).