International Diversification and the Home Bias Puzzle

International Diversification and the Home Bias Puzzle The idea behind international diversification is that by adding foreign assets to a domestic portfolio, investors reduce portfolio-level volatility and, thereby, generate better risk-adjusted returns. In any given period, portfolio returns in international markets may be higher or lower than returns generated in an investor's domestic market. However, over long holding periods international diversification seems to have delivered on the promise of reducing portfolio volatility and enhancing risk-adjusted returns.

Although international diversification is thought to reduce the volatility of returns, it is not actively pursued by many investors. The first argument put forward against international diversification is that there is increasing correlations in the stock markets around the world. While correlations change over time as the markets become more integrated the correlation between markets will increase. There is empirical evidence showing that stock markets tend to move together in the long run and it seems that stock markets take a long time to adjust to this long run.

Garrett and Spyrou (1999) investigate the existence of common trends in the increasingly important emerging equity markets of the Latin American and Asia-Pacific regions. While they find evidence of common trends, they do not rule out long run benefits to diversification. Taylor and Tonks (1989) also find evidence that stock markets move together in the long run after 1979 and suggest that there is no benefit to international diversification in the long run.

However, despite the fact there may a correlation between stock markets in the long run, it seems unlikely that this will be detrimental to diversification unless investors have very long horizons. There is also empirical evidence that shows that correlations between markets change over time. It is suggested that during tranquil periods, markets tend not to be that highly correlated across countries. However correlations during exceptional periods can be very high, for example during the 1987 stock market crash.

Longin and Solnik (1995) find that correlation is not related to market volatility but to the market trend. They find that correlations between markets tend to increase in bear markets but not in bull markets. Currency risk is also seen by some as a barrier to international diversification. Empirical studies indicate that the currency risk is smaller than the stock market risk although it is larger that the bond market risk.

The correlation between currency and stock market movements is found to be weak and this suggests that currency risk isn't really a barrier to international diversification. Other barriers to international investment include, political risk, regulations restricting participation by foreign investors, unfamiliarity with the market and transaction costs. If the transaction costs of investing in a foreign market are too high or the investor does not have enough information about the market in which he is wishing to invest then these provide a barrier to international diversification.

The first question to consider is: why are correlations between stock markets so low? The first reason, given to explain the low correlation between stock markets and thus the benefits to international diversification, is that countries have different industrial compositions and different industrial structures. This means that industries are imperfectly correlated across countries. Therefore if investors undertake international diversification they are benefiting from industrial diversification.

However Heston and Rouwenhurst (1995) find that the benefits from international diversification are mainly from geographical diversification rather than from industrial diversification. Griffin and Karolyi (1998) also find that industrial structure explains very little of the cross-sectional difference in country return volatility, and that the low correlation between country indices is almost completely due to country-specific sources of return variation. Diversification across countries within an industry is a much more effective tool for risk reduction than industry diversification within a country.

The second reason offered as to why the correlation between international stock markets is so low is that differences in the institutional and legal frameworks, fiscal and monetary policy and so on give rise to large country-specific variations in returns. As mentioned above Griffin and Korolyi (1998) find that country specific components dominate industry effects. It has been suggested that as Europe integrates its fiscal policy and heads towards the Euro that these country specific factors will become extinct.

However this does not seem the case at the moment as there is persistent flouting of the rules by large member states such as Germany and France. The home bias puzzle: For example an investor has two risky assets, domestic and foreign equity. The investor with a mean-variance utility function has an optimal weight for foreign shares in the portfolio of (Lewis 1999): Where: r – real return – coefficient of relative risk aversion The first term influences the return and it is the demand that arises from higher potential returns on foreign stock.

The second term is the share that would give the minimum variance portfolio. Lewis (1999) finds that the more risk averse the investor, the less they invest in foreign equities. This is not a new phenomenon as it is also found by French and Porteba (1991) who document the home bias in the UK and Japanese investors' investment decisions. Overall, Lewis (1999) finds that there is a home equity bias and finds several reasons that could explain it, however he finds that there is no definitive answer to the home bias puzzle. Some possible explanations have been offered as to why there is home bias.

These include, hedging, costs and behavioural explanations. The first explanation about hedging says that investors hedge against inflation. As it is a widely held belief that Purchasing Power Parity doesn't hold in the short run and therefore real returns aren't the same across countries then investors have to hedge against changes in the inflation rate. Therefore deviations from PPP can introduce demand for foreign equity to hedge inflation risk. Cooper and Kaplanis (1994) find that inflation hedging cannot explain the home bias.

They also find that direct observable costs cannot explain the home bias puzzle, which leads to the second explanation offered for the home bias puzzle. The second explanation offered as to why investors are biased to the home market is that the cost of investing in foreign equity exceeds the gains. For example, investing in a foreign company that was not cross listed would require the investor to research the company as to whether it was a suitable company to invest in and what the accounting practices of the country were. This could be costly.

Adjusting formula (1) to show this: assume there is a constant proportional fee (representing such things as taxes and costs) on foreign equity: The higher ? the higher the costs and as a result the less attractive foreign equity is. The final explanation offered to explain the home bias puzzle is the one of behavioural explanations. It is suggested that investors are more optimistic about their own markets than foreign markets. Strong and Xu (2003) use the Merrill-Lynch survey of fund managers and focus on fund managers in the US, UK, Japan and Continental Europe.

They find that fund managers are relatively more optimistic about the domestic equity market. On average 52% of US managers are bullish about US equities while 63%, 53% and 54% of UK, European and Japanese fund managers respectively are bearish about US equities. Overall it is hard to find one reason that will explain the home equity bias and despite several explanations being given it remains a mystery why risk averse investors fail to diversify their portfolios internationally.