The Equity home bias puzzle is the term given to describe the fact that individuals and institutions in most countries hold only modest amounts of foreign equity. This is puzzling since observed returns on national equity portfolios suggest substantial benefits from international diversification. The home bias in equities was first documented by French and Poterba (1991) and Tesar and Werner (1995).
Coval and Moskowitz (1999) showed that home bias is not limited to international portfolios, but that the preference for investing close to home also applies to portfolios of domestic stocks. Specifically, they showed that U.S. investment managers exhibit a strong preference for locally headquartered firms, particularly small, highly leveraged firms that produce nontradable goods.
Maurice Obstfeld and Kenneth Rogoff identifies this as one of the six major puzzles in international macroeconomics. The others are the Feldstein-Horioka puzzle, the home bias in trade puzzle, the consumption correlations puzzle, the purchasing power and exchange rate disconnect puzzle, and the Baxter-Stockman neutrality of exchange rate regime puzzle.
The home bias also creates some less obvious problems for investors, by diminishing the cost of capital for companies it limits the shareholders' ability to influence management by threatening to walk out. It partly explains why foreign investors tend to be better at monitoring firms they invest into.
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