The Implications of the Home Bias in Equity Portfolios

Although the diversification benefits of international investment are well documented, many large equity portfolios remain heavily concentrated in their domestic stock market. The reason for this is sometimes given as a desire to hedge domestic inflation by holding domestic equities. The evidence is, however, that equities do not hedge inflation in this way for the types of investment horizon relevant to most portfolios. An alternative explanation is that there are costs, such as taxes, which prevent investors taking full advantage of international diversification. The magnitude of these costs necessary to explain the level of "home bias" is above the level of observable costs, such as withholding taxes. The implications of these results are that international capital markets are segmented not only by costs and restrictions, but also by other informational imperfections. They also imply that international corporate investment and financing decisions depend on the location of the investing company.