Abstract
Observed international diversification implies an investment home bias (IHB). Can bivariate preferences with a local domestic peer group rationalize the IHB? For example, it is argued that wishing to have a large correlation with the Standard and Poor’s 500 stock index (S&P 500 stock index) may induce an increase in the domestic investment weight by American investors and, hence, rationalize the IHB. While this argument is valid in the mean-variance framework, employing bivariate first-degree stochastic dominance (BFSD), we prove that this intuition is generally invalid. Counter intuitively, employing “keeping up with the Joneses” (KUJ) preference with actual international data even enhances the IHB phenomenon.
Highlights
The investment home bias (IHB) is well documented
We proved above that unless the marginal distributions are kept unchanged with a positive cross derivative, we do not have bivariate first-degree stochastic dominance (BFSD), and with a negative cross derivative, the required condition is unlikely to hold; generally we do not have IHB rationalization, regardless of the sign of the cross derivative
The empirical distributions of return of all countries are not identical, and the marginal distribution of the various diversified portfolios under consideration are not identical; the conditions of Proposition 1 are not intact; the BFSD does not exist with positive cross derivative
Summary
The investment home bias (IHB) is well documented. The US equity market accounts for about 35% of the world equity market, yet about 75% of Americans’ equity investment is allocated to the US market. The US equity IHB is in the magnitude of 40%. For most commonly employed utility functions, the univariate expected utility maximization does not support the relatively large domestic investment weight; the IHB puzzle emerges. It is advocated that the bivariate expected utility maximization rationalizes partially or fully the IHB. We employ the “keeping up with the Joneses” (KUJ) preference, where the investor’s wealth and the peer group’s wealth are the two attributes of this utility function, analyzing the peer effect on the empirically observed IHB phenomenon
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