A `Home Bias' Is Inhibiting Global Investment

Although capital markets are now global in scope, that doesn't mean that money always flows across borders seeking the highest return. At a conference held Aug. 19-21 in Jackson Hole, Wyo., under the aegis of the Federal Reserve Bank of Kansas City, Morris Goldstein and Michael Mussa of the International Monetary Fund argued that a "home bias" skews investment policy along familiar paths--within national borders. In other words, far less capital is directed abroad by U.S. and foreign investors than would be predicted by optimal portfolio strategies based on such considerations as risk, rate of return, and diversification.

The two economists cite recent studies that suggest that home bias during the 1980s cost U.S. institutional investors and their clients about two percentage points in rate of return. That is, they earned 2% less a year on funds that portfolio theory says should have been directed overseas. In Germany, a similar home bias may have cost investors as much as nine percentage points.

Why the bias? Goldstein and Mussa say investors are simply unfamiliar with the risks in foreign markets and tend to exaggerate them. Indeed, discussions with portfolio managers indicate that the bias extends to regions within a country, as well as overseas: "We conclude that there is a strong tendency even today for investors to be most knowledgeable and comfortable with investments in their own backyards."

Such results imply that large untapped profit opportunities abroad are still available to investors despite the increasing integration of global capital markets. Those able to research such opportunities and take advantage of them could reap significant rewards.

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