External Habit Formation and the Home Bias Puzzle

47 Pages Posted: 30 Oct 2002

See all articles by Stephen H. Shore

Stephen H. Shore

Georgia State University

Joshua S. White

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: November 2002

Abstract

The equity home bias, the observed lack of international diversification in equity portfolios, is a persistent puzzle in international finance. We propose an explanation for this puzzle based on external habit formation preferences. Agents' utility depends on the difference between consumption and a slow-moving subsistence level. The subsistence level, or external habit, is a backward-looking moving average of national aggregate consumption. We assume that a small group of agents holds primarily domestic securities. We can think of these agents as small business owners who are forced to hold domestic assets for agency reasons. If the remaining agents have external habit formation utility, then they will mimic the domestic bias of this small group.

We perform a calibration using consumption and asset return moments from several countries and show that this effect can potentially explain a large aggregate holding of domestic assets. The model performs especially well in explaining high equity home bias in small countries, where the observed lack of international diversification is most puzzling.

Suggested Citation

Shore, Stephen H. and White, Joshua S., External Habit Formation and the Home Bias Puzzle (November 2002). AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=334943 or http://dx.doi.org/10.2139/ssrn.334943

Stephen H. Shore (Contact Author)

Georgia State University ( email )

35 Broad Street
11th Floor
Atlanta, GA 30303-3083
United States

Joshua S. White

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
(217) 244-1166 (Phone)

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