The determinants of home bias puzzle in equity portfolio investment in Australia

Abstract

Despite the well documented gains from international diversification, investors continue to show a strong preference for investing in domestic assets, a phenomenon referred to in the literature as ‘home bias’. This bias comes at a price — a higher cost of capital for businesses. We estimate the share of foreign equity in a typical Australian equity portfolio to be approximately 17% while the standard portfolio theory suggests that the proportion ought to be in the order of 98%. Applying these proportions to the typical Australian portfolio would cause Australian borrowing costs to fall by approximately two percentage points. This paper provides a detailed analysis of the drivers of home bias from the perspective of an Australian investor. The results indicate that the typical Australian investor undervalues the benefits of international diversification by investing a proportionally larger share of their equity in domestic stocks relative to overseas markets. Evidence from our research indicates that trade, governance, market size, cross-border capital controls and transaction costs play a positive and statistically significant role in influencing Australian investor's home bias.