Domestic Versus International Portfolio Selection: A Statistical Examination of the Home Bias
Multinational Finance Journal, Vol. 6, No. 3 & 4
36 Pages Posted: 21 Jul 2003
The observed international home bias has traditionally been viewed as an anomaly. We provide statistical evidence contrary to this view within a mean-variance framework. We investigate two methods of estimating the expected return and covariance parameters: (i) the Bayes-Stein "shrinkage" algorithm, and (ii) the traditional Markowitz approach. In in-sample tests, neither the Bayes-Stein tangency allocation vector, nor the Markowitz tangency allocation vectors are significantly different from a 100% domestic allocation (i.e. extreme home bias). The result is robust to the shorting of equity, and across foreign exchange hedge strategies. We also conduct out-of-sample tests with a view toward investment performance. We find that a 100% domestic allocation typically outperforms both the Bayes-Stein and Markowitz tangency portfolios. Overall, the theorized gains to international diversification appear difficult to capture in practice, and hence investors exhibiting a strong home bias are not necessarily acting irrationally.
Keywords: Portfolio allocation, home bias, foreign exchange hedging, international finance
JEL Classification: F3, G11, G12, G15
Suggested Citation: Suggested Citation