WHY EMPIRICAL INTERNATIONAL PORTFOLIO MODELS FAIL - EVIDENCE THAT MODEL MISSPECIFICATION CREATES HOME ASSET BIAS

International portfolio models consistently predict that investors sho uld put much more of their wealth into foreign assets than they actual ly do-a result known as 'home asset bias'. We use actual international portfolio data to show how model misspecification contributes to this bias. We find that three widely-used simplifying assumptions produce optimal portfolio weights that are significantly different from the we ights produced by an unsimplified model. In particular, imposing the i nvalid assumption that PPP holds exaggerates the degree of 'home asset bias'. These findings suggest that researchers should pay greater att ention to empirical model specification in the future. Copyright (C) 1 996 Elsevier Science Ltd.