A rational explanation for home country bias

While modern portfolio theory predicts that investors should diversify acro ss international markets, corporate equity is essentially held by domestic investors. French and Poterba (1991) [French, K., Poterba, J., 1991. Invest or diversification and international equity markets. American Economic Revi ew 81, 222-226] suggest that in order for this bias to be justified, invest ors must hold optimistic expectations about their domestic markets and pess imistic expectations about their foreign markets. Tesar and Werner (1995) [ Tesar, L.L., Werner, I.M., 1995. Home bias and high turnover. Journal of In ternational Money and Finance 14, 467-492] find existing explanations for t he home equity bias unsatisfactory and conclude that the issue poses a chal lenge for portfolio theory. We develop a model that incorporates both the f oregone gains from diversification and the informational constraints of int ernational investing, and shows that home equity bias is consistent with ra tional mean-variance portfolio choice. Specifically, we prove that the natu re of estimation risk in international markets can be responsible for this phenomenon. We show that when the cross-market variability in the estimatio n errors of international markets' means far exceeds the cross-market varia bility in the means themselves, domestic dedication dominates international diversification. An examination of 11 international markets' returns over the last 25 years, from the perspective of German, Japanese and US investor s provides evidence consistent with this explanation. (C) 2000 Published by Elsevier Science Ltd. All rights reserved.