Question

In class we learned that investors should always hold a portfolio that is on the efficient frontier. In reality investors often hold a portfolio that is not on the efficient frontier. One reason for this is called home bias. Home bias refers to the fact that investors tend to have larger portfolio weights on assets that are located in the country in which they live. So, American investors tend to have a larger portfolio weight on American firms than is optimal. One explanation for the home bias puzzle is that investors often have less information about foreign investments than they do domestic ones, making it easier for them to forecast the returns on domestic stocks compared to foreign ones.

Assuming this theory is correct explain: How this helps to resolve the home bias puzzle in the context of the mean variance preferences?

Answer 1

The iefficient ifrontier iis ithe iset iof ioptimal iportfolios ithat ioffer ithe ihighest iexpected ireturn ifor ia idefined ilevel iof irisk ior ithe ilowest irisk ifor ia igiven ilevel iof iexpected ireturn. iPortfolios ithat ilie ibelow ithe iefficient ifrontier iare isub-optimal ibecause ithey ido inot iprovide ienough ireturn ifor ithe ilevel iof irisk. iPortfolios ithat icluster ito ithe iright iof ithe iefficient ifrontier iare isub-optimal ibecause ithey ihave ia ihigher ilevel iof irisk ifor ithe idefined irate iof ireturn.

1. Efficient ifrontier icomprises iinvestment iportfolios ithat ioffer ithe ihighest iexpected ireturn ifor ia ispecific ilevel iof irisk.

2. Returns iare idependent ion ithe iinvestment icombinations ithat imake iup ithe iportfolio.

3. The istandard ideviation iof ia isecurity iis isynonymous iwith irisk. iLower icovariance ibetween iportfolio isecurities iresults iin ilower iportfolio istandard ideviation.

4. Successful ioptimization iof ithe ireturn iversus irisk iparadigm ishould iplace ia iportfolio ialong ithe iefficient ifrontier iline.

5. Optimal iportfolios ithat icomprise ithe iefficient ifrontier itend ito ihave ia ihigher idegree iof idiversification.

Home ibias iis ithe itendency ifor iinvestors ito iinvest ithe imajority iof itheir iportfolio iin idomestic iequities, iignoring ithe ibenefits iof idiversifying iinto iforeign iequities. iThis ibias iwas ioriginally ibelieved ito ihave iarisen ias ia iresult iof ithe iextra idifficulties iassociated iwith iinvesting iin iforeign iequities, isuch ias ilegal irestrictions iand iadditional itransaction icosts. iOther iinvestors imay isimply iexhibit ihome ibias idue ito ia ipreference ifor iinvesting iin iwhat ithey iare ialready ifamiliar iwith irather ithan imoving iinto ithe iunknown.

Investing iin iforeign iequities itends ito ilower ithe iamount iof isystematic irisk iin ia iportfolio ibecause iforeign iinvestments iare iless ilikely ito ibe iaffected iby idomestic imarket ichanges. iHowever, iinvestors ifrom iall iover ithe iworld itend ito ibe ibiased itoward iinvesting iin itheir iparticular idomestic iequities. iFor iexample, ian iacademic istudy ifrom ithe ilate i1980s ishowed ithat ialthough iSweden ipossessed ia icapitalization ithat ionly irepresented iabout ione ipercent iof ithe iworld's imarket ivalue iof iequities, iSwedish iinvestors iput itheir imoney ialmost iexclusively iinto idomestic iinvestments.

Diversification ireduces irisk iby iallocating iinvestments iamong ivarious iasset itypes, igeographic iregions iand iindustries. iIt iaims ito imaximize ireturns iby iinvesting iacross idifferent iareas ito ilessen ithe ichance ithat ia imarket ievent ican ihave ia idebilitating ieffect ion ian ientire iportfolio. iBy inot iinvesting ibeyond ione's iparticular icountry ior iregion, iinvestors ican ibecome itoo iconcentrated iin ithe imovements iof itheir idomestic imarket iand ieconomy, iincreasing ithe ivolatility irisk ilevel ito ithe iportfolio. iWhen ian iinvestor iis inot iproperly iglobally idiversified, ithey imay imiss iopportunities ito iinvest iin ifaster-growing imarkets.

Further idiversification ibenefits ican ibe igained iby iinvesting iin iforeign imarkets isince ithey itend ito ibe iless-closely icorrelated iwith idomestic iperformance. iFor iexample, ian ieconomic idownturn iin ithe iU.S. ieconomy imay inot inegatively iaffect iChina's ieconomy itoo idramatically; itherefore, iholding iinvestments iin iChinese iequities ican igive iinvestors ia ilevel iof iprotection iagainst ilosses idue ito ia inegative ichange iin ithe iAmerican ieconomy.