Question

a) What is equity home bias and why are proponents of international portfolio diversification puzzled by the home bias phenomenon?

Write 350 words (fix). No plagiarism plz.

Answer 1

Equity Home bias is the tendency for investors to invest the majority of their portfolio in domestic equites ignoring the benefits of diversifying ino foreign equity.So basically it describes the fact that individuals and institutions in most countries hold only small amounts of foreign equity.

The proponents of international diversification is puzzling by this home bias phenomenon because its observed that returns on national equity portfolios suggest substantial benefits from them.The 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.

Investing in foreign equities tends to lower the amount of systematic risk in a portfolio because foreign investments are less likely to be affected by domestic market changes. However, investors from all over the world tend to be biased toward investing in their particular domestic equities. For example, an academic study from the late 1980s showed that although Sweden possessed a capitalization that only represented about one percent of the world's market value of equities, Swedish investors put their money almost exclusively into domestic investments. Transaction costs and unfamiliarity used to be major barriers for investors. Now, mutual funds and exchange-traded funds both provide a relatively easy and low-cost way to diversify across international investments that may otherwise be more difficult to access on their own. Moreover, an internationally focussed financial media and the free flow of information has made owning and monitoring foreign stocks much easier.

Diversification of risk is central to both practical investing and finance theory. In practice it is widely accepted that an investor’s equity portfolio should be highly diversified unless there are particular reasons such as tax, information differences, hedging needs, or non-financial motives such as “ethical” investing for the investor to deviate from this norm. The world equity-market portfolio as the standard, is the sense that any deviation between observed portfolio weights and the world market weights is regarded as potentially anomalous.