Demystifying the 'home bias' effect: the benefits of international diversification

Abstract

The present study aims to highlight the beneficial virtues of diversification through internationalisation and distribution to multiple asset classes, traditional and alternative, for a Greek investor who exhibits a historically high local bias. A special reference is made to public pension funds that are 'forced' to invest, predominantly, in Greek assets, and, especially Greek Government securities, due to a very restrictive and binding legal framework. Applying modern portfolio theory to explore the potential benefits of holding international assets together with Greek assets, and monthly data covering the December 1998-March 2015 period, we confirm the benefits of international diversification. We find that if Greek investors allocate a substantial part of their risk budget in foreign markets, they can achieve significant reduction in portfolio risk and superior portfolio return. Local asset portfolios clearly represent a sub-optimal solution. The results hold for different stages of the economic cycle (recessions and/or expansions).