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Confidence in the Familiar: An International Perspective

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  • Li, Kai

Abstract

One striking feature of international portfolio investment is the extent to which equity portfolios are concentrated in the domestic equity market of the investor—the home bias puzzle. I examine the role of investors' perception of foreign investment risk on their portfolio choices. The expected returns and risk of foreign investment are specified through an asset pricing model with the home portfolio being the benchmark asset—Pastor's (2000) domestic CAPM. The model serves as a reference point around which investors can center their prior beliefs. I focus on investors' prior beliefs that are consistent with the literature on confidence in the familiar—foreign equities, in terms of both expected returns and risk, being viewed less favorably than domestic equities. These prior beliefs are then combined with the data on G7 equities, and the revised beliefs are used to obtain the global optimal asset allocation. To hold predominantly domestic equities, each G7 investor has to believe that the risk of foreign investment is several times higher than the actual risk. The home bias is more of a puzzle for a U.S. investor during the 1970s. Specifying investors' prior beliefs around the world CAPM does not help resolve the puzzle.

Suggested Citation

  • Li, Kai, 2004. "Confidence in the Familiar: An International Perspective," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(1), pages 47-68, March.
    • Handle: RePEc:cup:jfinqa:v:39:y:2004:i:01:p:47-68_00
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    Cited by:

    1. Anna Faelten & Miles Gietzmann & Valeriya Vitkova, 2014. "Naked M&A Transactions: How the Lack of Local Expertise in Cross-Border Deals Can Negatively Affect Acquirer Performance – and How Informed Institutional Investors can Mitigate This Effect," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 41(3-4), pages 469-506, April.
    2. Maroney, James J. & McGarry, Clodagh & Ó hÓgartaigh, Ciarán, 2008. "Familiarity, home bias and investors’ reactions to 20-F reconciliation gains and losses and perceptions of the quality of accounting principles," The British Accounting Review, Elsevier, vol. 40(2), pages 103-122.
    3. Martijn Boermans & Ian Cooper & Piet Sercu & Rosanne Vanpée, 2022. "Foreign bias in equity portfolios: Informational advantage or familiarity bias?," Working Papers 742, DNB.
    4. Mishra, Anil V., 2015. "Measures of equity home bias puzzle," Journal of Empirical Finance, Elsevier, vol. 34(C), pages 293-312.
    5. Giofré, Maela M., 2008. "Bias in foreign equity portfolios: households versus professional investors," MPRA Paper 13929, University Library of Munich, Germany.
    6. Anil V. Mishra, 2017. "Foreign bias in Australia's international equity holdings," Review of Financial Economics, John Wiley & Sons, vol. 33(1), pages 41-54, April.
    7. Rizwan Mushtaq & Syed Zulfiqar Ali Shah, 2014. "International Portfolio Diversification: United States and South Asian Equity Markets," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 61(2), pages 241-252, March.
    8. Giofré, Maela, 2009. "The role of information asymmetries and inflation hedging in international equity portfolios," Journal of Multinational Financial Management, Elsevier, vol. 19(4), pages 237-255, October.
    9. Chen, Ke & Vitiello, Luiz & Hyde, Stuart & Poon, Ser-Huang, 2018. "The reality of stock market jumps diversification," Journal of International Money and Finance, Elsevier, vol. 86(C), pages 171-188.
    10. Driessen, Joost & Laeven, Luc, 2007. "International portfolio diversification benefits: Cross-country evidence from a local perspective," Journal of Banking & Finance, Elsevier, vol. 31(6), pages 1693-1712, June.
    11. Mishra, Anil V., 2016. "Foreign bias in Australian-domiciled mutual fund holdings," Pacific-Basin Finance Journal, Elsevier, vol. 39(C), pages 101-123.
    12. Jagannathan, Murali & Jiao, Wei & Karolyi, G. Andrew, 2022. "Is there a home field advantage in global markets?," Journal of Financial Economics, Elsevier, vol. 143(2), pages 742-770.
    13. Ang, James & de Jong, Abe & van der Poel, Marieke, 2014. "Does familiarity with business segments affect CEOs' divestment decisions?," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 58-74.
    14. Baele, Lieven & Pungulescu, Crina & Ter Horst, Jenke, 2007. "Model uncertainty, financial market integration and the home bias puzzle," Journal of International Money and Finance, Elsevier, vol. 26(4), pages 606-630, June.
    15. Wen-Lin Wu & Yin-Feng Gau, 2017. "Home bias in portfolio choices: social learning among partially informed agents," Review of Quantitative Finance and Accounting, Springer, vol. 48(2), pages 527-556, February.
    16. Giofré, Maela, 2014. "Domestic investor protection and foreign portfolio investment," Journal of Banking & Finance, Elsevier, vol. 46(C), pages 355-371.
    17. Laeven, Luc & Chhaochharia, Vidhi, 2008. "Sovereign Wealth Funds: Their Investment Strategies and Performance," CEPR Discussion Papers 6959, C.E.P.R. Discussion Papers.
    18. De Moor, Lieven & Sercu, Piet & Vanpée, Rosanne, 2010. "The plausibility of risk estimates and implied costs to international equity investments," Journal of Empirical Finance, Elsevier, vol. 17(4), pages 623-644, September.
    19. Giofré, Maela, 2013. "International diversification: Households versus institutional investors," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 145-176.
    20. Eduard Gaar & David Scherer & Dirk Schiereck, 2022. "The home bias and the local bias: A survey," Management Review Quarterly, Springer, vol. 72(1), pages 21-57, February.
    21. Chiou, Wan-Jiun Paul & Lee, Alice C. & Chang, Chiu-Chi A., 2009. "Do investors still benefit from international diversification with investment constraints?," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 448-483, May.
    22. Geoffrey J. Warren, 2010. "Equity home bias in Australian superannuation funds," Australian Journal of Management, Australian School of Business, vol. 35(1), pages 69-93, April.
    23. Matthew Hood & John Nofsinger & Abhishek Varma, 2014. "Conservation, Discrimination, and Salvation: Investors’ Social Concerns in the Stock Market," Journal of Financial Services Research, Springer;Western Finance Association, vol. 45(1), pages 5-37, February.
    24. Huang, Alan G. & Kalimipalli, Madhu & Nayak, Subhankar & Ramchand, Latha, 2019. "Risk mitigation by institutional participants in the secondary market: Evidence from foreign Rule 144A debt market," Journal of Banking & Finance, Elsevier, vol. 99(C), pages 202-221.
    25. Anna Faelten & Miles Gietzmann & Valeriya Vitkova, 2015. "Learning from your investors: can the geographical composition of institutional investors affect the chance of success in international M&A deals?," Journal of Management & Governance, Springer;Accademia Italiana di Economia Aziendale (AIDEA), vol. 19(1), pages 47-69, February.

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