Equity home bias: investors' sentiments and views

Modern portfolio theory suggests that the best strategy to reduce portfolio risk is to diversify internationally rather than nationally. However, despite the gains from international portfolio diversification investors still overweight their portfolios with the domestic assets. This is referred to as the 'equity home bias'. Many researches based on traditional theory fail in explaining how financial decisions are truly made. In this work, we explore behavioural finance to develop a model in which we identify a new covariance matrix and we allow investors to express sentiment and views about domestic and foreign markets separately. Our results have the potential to explain the home bias puzzle.