Hello, welcome back. In this lecture you're going to learn about the large body of evidence that suggests that investors diverse their portfolio holdings much less than what is recommended by optimal portfolio choice models. Specifically you're going to learn about the what we called home bias puzzle. The phenomenon the investors have a strong preference for local stocks in their portfolio choices. Finally we will also explore some of the explanations that have been provided for home bias, such as familiarity and ambiguity aversion. First of all, what is home bias puzzle? Well, the home bias puzzle refers to the fact that investors all around the world have a tendency to under weigh foreign equities in their portfolio of risky assets. You may recall from the optimal portfolio choice exercises we did in our last course. Combining US equities with other international equity markets, diversified away, significant amount of systematic risk, and offered better risk and return tradeoffs. In fact, we saw that holding a portfolio that is 100% invested in US equities was inferior to holding a portfolio, for example, that consisted of investing in G5 countries. However, what we observe is not just in the US, but everywhere around the world, is that investors have a preference towards holding domestic equities in their portfolios. So for example, if US investors allocated their stock investments across countries in the world in proportion to their market capitalization, they would have placed only 36% of their equity in the US. And the remaining 64% would go in foreign markets. But what we observe is that the US investors mainly concentrate their holdings in US stocks, and invest more than 80% of their overall equity investments in the US. And this is not unique to the US. It is even more striking for European investors and similarly for other investors in other countries. In other words home bias is a pretty robust pattern. It extends across countries, even for investors in small countries where one would expect a greater need for investing in foreign equities. In fact, some cities have found an analog to home bias even within countries. There is evidence that even within a given country, investors are more likely to hold and trade stocks that are located geographically close to them. Similarly studies show that investors display a strong bias towards, for example, holding own company stock in their 401k plans. In other words, investors deliberately over-weigh the fraction invested in the company stock in their retirement portfolios. Now as we've seen in the previous course, given that their labor income is already tied to these companies that they work for. This does not bode well for their diversification of course, all right? And it creates even greater under diversification. So what explains this pattern in investment behavior? Well aversion to ambiguity and likeness for familiarity provide a simple way of understanding these examples of insufficient diversification. It's not very hard to understand why investors might find their own national stock markets or their own companies more familiar and less ambiguous. Or why they may find firms that are located close to them geographically, more familiar than those located further away. Since familiar assets are more attractive, people invest more heavily in those and little or nothing at all in assets that appear more ambiguous to them. And give up the benefits of diversification. Now, preference for familiarity or aversion to ambiguity, however, may not be the entire story in understanding home bias puzzle. Studies show that US mutual fund managers also tend to hold more of the stocks of the companies that are headquartered close to them. So in other words, if you're a fund manager based in Chicago, for example, you're more likely to hold more of your portfolio invested in companies that are located in Chicago than, for example, a fund manager in San Francisco. More importantly, however, there is evidence in fact, that these local holdings also subsequently perform well. Even better than their non-local holdings. So what's going on here? Well clearly this suggests that maybe there is an information story at work here as well, right? It is very plausible that it is less costly for the fund manager in Chicago, right? To learn about and research companies in Chicago, that are close, that are located close to her. And that's why she has an information advantage, that she can exploit, right? By focusing on those firms to pick out the ones with higher expected returns. So, in this lecture, you learned that investors diversify their portfolio much less than what is recommended by optimal portfolio choice models. Investors prefer investing in domestic stocks, local stocks, of stocks of their own companies, right? And, preference for familiarity, or aversion to ambiguity, may offer some understanding for these patterns.
