What is the Economic Cost of the Investment Home Bias?

Abstract

American investors tilt to overinvest domestically, well-known as a home bias puzzle. Hedging various types of domestic risks, differences in taxes and transaction costs, informational frictions and behavioral effects are commonly employed in an attempt to explain the home bias puzzle. We show in this study that even abstracting from the above factors, nowadays there is a simple rationalization for the home bias, let alone when these factors are also accounted for. We define economic home bias (EHB) to distinguish it from investment home bias (IHB), where the IHB measures investment weights and the EHB measures economic cost. We find that for reasonable degrees of risk aversion and with 25 years multivariate distribution, that the annual EHB loss is merely 0.1%, despite the large domestic overinvestment of about 40% in the US. Thus, with market globalization and high correlations, overinvesting domestically is not irrational implying that the home bias puzzle has vanished.