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Confidence in the Familiar: An International Perspective

Published online by Cambridge University Press:  06 April 2009

Kai Li
Kai Li
Affiliation:
kai.li@sauder.ubc.ca, Sauder School of Business, University of British Columbia, 2053 Main Mall, Vancouver, B.C. Canada V6T 1Z2.
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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 39 , Issue 1 , March 2004 , pp. 47 - 68
Copyright
Copyright © School of Business Administration, University of Washington 2004

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