Analyzing a Behavioral Finance Phenomenon

Assignment 2: Analyzing a behavioral finance phenomenon

For this assignment I chose to analyze the behavioral finance phenomenon that is called the ‘ Home Bias ‘. The Home Bias phenomenon refers to the tendency of individuals to make financial investments in their home country rather than in foreign markets.
Some examples : people willing to invest in real estate, tend to do so by buying real estate in their home country rather than in a foreign country; People who hold a portfolio of stocks tend to hold a relatively high percentage of stock from companies based in their home country, rather than fully exploiting the opportunity of diversifying their portfolio by holding stock from different countries.  

Rational investors are expected to maximize the efficiency of their portfolio, to realize the highest possible risk-adjusted return on their investments. The Home Bias goes against this rational behavior, because it goes against an important concept in investment portfolio management, namely diversification. Diversifying is a technique that mixes a wide variety of investments in a portfolio. A portfolio that consists of different kind of investments will, on average, yield higher returns and pose lower risk than any individual investment found within that portfolio. Important is to state that the benefits of diversifying only hold if the securities in the portfolio are not perfectly correlated. Foreign securities tend to be less closely correlated with domestic investments, this shows that the Home Bias phenomenon goes against the rational behavior expected from rational investors.
The Home Bias can be linked to the familiarity bias, a cognitive bias of preference to remain confined to what is familiar and known. Humans have a tendency to believe more in the choices they recognize and are more aware of, as unfamiliarity makes them uncomfortable and unsure.

A 2014 study by Dlugosch, Horn and Wang studied portfolio diversification in an experimental decision task, where asset returns depend on a draw from an ambiguous urn. Holding other information identical and controlling for the level of ambiguity, they found that labeling assets as being familiar or from the homeland of subjects increases portfolio weight by around 25%, respectively, although the return-generating process remains unaffected. Importantly, they only found these effects when the returns of assets are highly ambiguous. The ambiguity robust mean-variance model accurately predicted benchmark portfolio weights of the experimental control group, where assets are not labeled: subjects allocate more wealth to assets with low ambiguity. For treatment group portfolios, which show a bias towards assets with a familiar or homeland label, the model did not hold. This misdiversification against the benchmark portfolio can be rationalized via the concept of source dependence of uncertainty attitudes.