Equity home bias: Can information cost explain the puzzle?

Most stock market investors believe that the ideal equity portfolio should be well diversified to lower overall portfolio risk. International financial markets offer a means for diversification, but most investors do not exploit this risk-sharing opportunity and instead hold large shares of their portfolios in domestic stocks-a tendency called home bias. ; To measure how severe home bias is, the author introduces a method of quantifying it. A simple asset allocation model is used to determine the shadow cost of foreign investment-that is, the perceived annual cost of foreign equity necessary to create a bias away from perfect international risk sharing and toward domestic equity. The model shows that in most industrialized nations the shadow costs would have to be unrealistically high to account for home bias. In the United States the home bias is almost 150 basis points per year, by far the lowest among all industrialized nations. ; The article then discusses a popular explanation for home bias: information cost. This theory argues that investors face lower costs for gathering information on their domestic assets than on foreign assets and are therefore biased toward holding domestic equity. While this explanation is intuitive, the author demonstrates, using both a naive model and a rational expectations model, that the theory is unable to account for observed patterns of home bias. The author thus concludes that home bias is still a puzzle.