Time Varying Risk Aversion, Familiarity Bias, and Portfolio Concentration During Market Uncertainty

Abstract

It is well established that international portfolios are far substantially under-diversified, contrary to predictions of traditional finance theory. Even after controlling for market segmentation and “investability” of foreign markets, portfolio under-diversification remains a puzzle. I study global portfolio under-diversification during periods of varying market uncertainty. My empirical hypotheses are based on a psychological theory that relates uncertainty in the markets to increases in investors’ risk aversion which in turn increases investors’ proneness to familiarity bias. I hypothesize that during heightened market uncertainty, investors become more under-diversified and focus their holdings in familiar markets. I indeed show that in addition to “flight to quality” there exists a strong “flight to familiarity” effect, when global volatility is high. The average home bias and country concentration of investors’ foreign holdings are of 8-10% larger during periods of heightened market uncertainty. In addition, familiarity variables that affect portfolio allocation, such as common language, culture, and geographical distance become more significant drivers of equity allocation.