How Much Foreign Stocks? Bayesian Approaches to Asset Allocation Can Explain the Home Bias of US Investors

Abstract

US investors hold much less foreign stocks than mean/variance analysis applied to historical data predicts. In this article, we investigate whether this home bias can be explained by Bayesian approaches to international asset allocation. In contrast to mean/variance analysis, Bayesian approaches employ different techniques for obtaining the set of expected returns. They shrink the sample means towards a reference point that is inferred from economic theory. We also show that one of the Bayesian approaches leads to the same implications for asset allocation as the mean-variance/tracking error criterion. In both cases, the optimal portfolio is a combination of the market portfolio and the mean/variance efficient portfolio with the highest Sharpe ratio. Applying the Bayesian approaches to the subject of international diversification, we find that a substantial home bias can be explained when a US investor has a strong belief in the global mean/variance efficiency of the US market portfolio and when he has a high regret aversion of falling behind the US market portfolio. We also find that the current level of home bias can be justified whenever regret aversion is significantly higher than risk aversion. Finally, we compare the Bayesian approaches to mean/variance analysis in an empirical out-of-sample study. The Bayesian approaches prove to be superior to mean/variance optimized portfolios in terms of higher risk-adjusted performance and lower turnover. However, they do not systematically outperform the US market portfolio or the minimum-variance portfolio.