Confidence in the Familiar : An International Perspective

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. In this paper, I examine the role of investors' perception of the risk of foreign investment 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 - the domestic CAPM of Pastor (2000). The model serves as a point of reference 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. I find that in order 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 US investor during the 1970s. Specifying investors' prior beliefs around the world CAPM does not help resolve the puzzle