‘Home Bias’ Phenomenon Challenge the View That Investors Are Rational

This essay will explain what rationality of investors and home bias are and then discuss to what extent the ‘home bias’ phenomenon challenges the view that investors are rational.

In neoclassical economics, investors are supposed to be rational, which includes 3 points(assumption)?, 1) “people have rational preferences across possible outcomes or states of nature”; 2) “people maximize utility and firms maximize profits”; and 3) “people make independent decisions based on all relevant information”(Ackert& Deaves 2010, p.4). These points here are supposed to judge whether investors are rational or not in this essay.

Home bias phenomenon might probably challenge the view that investors are rational. Home bias is the tendency of investors to invest in a large amount of domestic equities, despite the potential benefits of diversified foreign equities (Tesa & Werner, 1995). If investors are rational, investors should look for diversification of portfolio in international markets because it has been recognized for a long time that potential profits can be gained by the diversification of investment portfolios across national markets (Tesa & Werner, 1995). But as French & Poterba(1991) show, most investors hold nearly all of their wealth in domestic. In the five biggest stock markets of the world, 92.2 percent of ownership in USA stock market is hold by domestic investors, 95.7 percent in Japan, 92 percent in United Kingdom, 89.4 percent in France, and 79 percent in Germany. This shows “home bias” phenomenon heavily exists.

To some extent, investors are supposed to be not totally rational. Rational investors should invest for highest profit and comparative lowest risk according to the definition of investors’ ration mentioned in paragraph 2 (Ackert & Deaves, 2010). Under these, international diversified portfolio is the best choice has been proved by some researchers. Tesa & Werner (1995) find that diversification of international portfolio contributes to gains according to pure risk reduction. And they also discover that comparing with the value standard theories would predict, the percentage of oversea assets is still significantly small in the portfolios. They draw the conclusion that domestic securities in national portfolios exists strong bias and investors are irrational on this.

Their conclusion is doubted by some voice. It is argued by some people that there are “high transactions costs associated with trading foreign securities” ( Tesa & Werner, 1995). However, such argument seems not to be tenable. Tesa and Werner (1995) observe that international investors adjusting the size and the composition of their portfolios at a considerable high frequency, even though most of these adjustments have little influence on net positions of investment. This find indicates that transactions costs cannot account for the reluctance of investors to diversified international portfolios. Therefore, investors are supposed to be irrational because they may violate the first and second points of investor ration definition mentioned in paragraph 2.

It still cannot be concluded that investors are irrational although investors show apparent reluctance on international diversified portfolio. According to the definition of investor ration mentioned in paragraph 2, the last one points out that investors make decisions independently based on all relevant information (Ackert& Deaves). In this point, the key problem is the “relevant information”. It is obviously that information is not equally available to different groups of investors, which called information asymmetry, especially between different foreign markets. For example, time lag cannot be eliminated even though communication technology is well developed today. It can be imaged that very few investors in United Kingdom are willing to watch stock market in China at mid night. As a result, investors assess the risk of different investments not only basing on historical standard deviation; investors tend to impute additional “risk” to foreign asserts because they have less or lagging information about foreign economic environment and markets. (French & Poterba, 1991)

Information asymmetry can cause another problem pointed out by French & Poterba (1991)is that return expectations of investors in different countries vary systematically; it is hard for investors to learn that expected returns in domestic markets are not systematically higher than those abroad because estimating expected returns in equity markets is statistical uncertain. Apart from information asymmetry, tax burdens also should be taken into consideration. Tax burdens on foreign equity interest are higher than domestic, leading investors toward holding domestic equity (French & Poterba, 1991). Therefore, it is hard to say investors are irrational solely because of the preference of investing in domestic equities.

Essay plan
Question:
To what extent does the ‘home bias’ phenomenon challenge the view that investors are rational?

Thesis statement
This essay will explain what ‘ration of investors’ and ‘home bias’ are and then discuss to what extent the ‘home bias’ phenomenon challenges the view that investors are rational.

What is investor ration?
•Definition from Behavioral finance: psychology, decision-making, and markets. (Ackert& Deaves, 2010)

What is home bias and to what extent it exists?
•Data of domestic ownership shares from research by French and Poterba (1991) •Description of “home bias” from Tesar and Werner (1995)

Why investors are irrational?
•Reference to assumption 1 and 2 about investor ration (Ackert& Deaves, 2010) •Potential gains from diversification of international portfolio (Tesar & Werner, 1995) •The reason why transactions costs cannot account for “home bias” (Tesar & Werner, 1995)

Why investors are rational?
•Reference to assumption 3 about investor ration (Ackert& Deaves, 2010) •General explanations for information asymmetry (French & Poterba, 1991) •Effects of tax burdens on investment decision (French & Poterba, 1991)

Reference:

French, K. and Poterba, J. (1991) Investor Diversification and International Equity Markets. American Economic Review, 81 (2), pp. 222–226.

Tesar, L. and Werner, I. (1995) Home Bias and High Turnover. Journal of International Money and Finance, 14 (4), pp. 467–492.

Ackert, L. F. and Deaves, R. (2010) Behavioral finance: psychology, decision-making, and markets. Ohio, USA: South-western Cengage Learning.