Equity home bias puzzle
Encyclopedia
The Equity home bias puzzle is the term given to describe the fact that individuals and institutions in most countries hold only 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) and Tesar and Werner (1995).
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.
Maurice Obstfeld
and Kenneth Rogoff
identifies this as one of the six major puzzles in international macroeconomics. 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.
The home bias also creates some less obvious problems for investors, by diminishing the cost of capital for companies it limits the shareholders' ability to influence management by threatening to walk out. It partly explains why foreign investors tend to be better at monitoring firms they invest into.
Another hypothesis is that investor
s have superior access to information about local firms or economic conditions. But as van Nieuwerburgh and Veldkamp (2005) point out, this seems to replace the assumption of capital immobility with the assumption of information immobility.
In some countries, like Belgium
, holding stocks of foreign companies implies a double taxation on dividends, once in the country of the company and once in the country of the stockholder, while domestic stock dividends are taxed only once.
Stocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
. This is puzzling since observed returns on national equity portfolios
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
suggest substantial benefits from international diversification
Diversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
. The home bias in equities was first documented by French
Kenneth French
Kenneth Ronald "Ken" French is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business, Dartmouth College. He has previously been a faculty member at MIT, the Yale School of Management, and the University of Chicago Booth School of Business...
and Poterba
James M. Poterba
James Michael "Jim" Poterba is an American economist, Mitsui Professor of Economics at the Massachusetts Institute of Technology, and current NBER president and chief executive officer.- Early years :...
(1991) and Tesar and Werner (1995).
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
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
of domestic stocks. Specifically, they showed that U.S. investment managers exhibit a strong preference for locally headquartered firms, particularly small, highly leveraged
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
firms that produce nontradable goods.
Maurice Obstfeld
Maurice Obstfeld
Maurice Moses "Maury" Obstfeld is a professor of economics at the University of California, Berkeley.He is well known for his work in international economics. He is among the most influential economists in the world according to IDEAS/RePEc....
and Kenneth Rogoff
Kenneth Rogoff
Kenneth Saul "Ken" Rogoff is currently the Thomas D. Cabot Professor of Public Policy and Professor of Economics at Harvard University. He is also a chess Grandmaster.-Early life:...
identifies this as one of the six major puzzles in international macroeconomics. The others are the Feldstein-Horioka puzzle
Feldstein-Horioka puzzle
The Feldstein-Horioka puzzle is a widely-discussed problem in macroeconomics and international finance, first documented by Martin Feldstein and Charles Horioka in an 1980 paper. According to economic theory, if we assume that investors that are able to easily invest anywhere in the world, they ...
, the home bias in trade puzzle
Home bias in trade puzzle
The Home bias in trade puzzle is a widely-discussed problem in macroeconomics and international finance, first documented by John T. McCallum in an article from 1995....
, the consumption correlations puzzle
Backus-Kehoe-Kydland puzzle
In economics, the Backus–Kehoe–Kydland consumption correlation puzzle, also known as the BKK puzzle, is the observation that consumption is much less correlated across countries than output.In an Arrow–Debreu economy, i.e...
, the purchasing power and exchange rate disconnect puzzle, and the Baxter-Stockman neutrality of exchange rate regime puzzle.
The home bias also creates some less obvious problems for investors, by diminishing the cost of capital for companies it limits the shareholders' ability to influence management by threatening to walk out. It partly explains why foreign investors tend to be better at monitoring firms they invest into.
Attempts to resolve the puzzle
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 investor
Investor
An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
s have superior access to information about local firms or economic conditions. But as van Nieuwerburgh and Veldkamp (2005) point out, this seems to replace the assumption of capital immobility with the assumption of information immobility.
In some countries, like Belgium
Belgium
Belgium , officially the Kingdom of Belgium, is a federal state in Western Europe. It is a founding member of the European Union and hosts the EU's headquarters, and those of several other major international organisations such as NATO.Belgium is also a member of, or affiliated to, many...
, holding stocks of foreign companies implies a double taxation on dividends, once in the country of the company and once in the country of the stockholder, while domestic stock dividends are taxed only once.