International Portfolio Investment and Home Bias

Abstract

The home bias puzzle—investors’ pronounced tendency to underweight foreign equities relative to the predictions of standard portfolio theory—is among international finance’s most studied and most debated empirical anomalies. Modern portfolio theory predicts that investors should hold the world market portfolio, with each country’s equities weighted by its share of global market capitalization. In practice, investors in every country dramatically overweight domestic equities: U.S. investors held approximately 75% of their equity portfolios in domestic equities in 2020, despite the U.S. constituting approximately 56% of global market capitalization. French and Poterba (1991) in the American Economic Review (81(2): 222–226) first systematically documented this home bias and estimated that implied expected return differentials required to explain it (domestic investors requiring 3–4% higher expected returns from foreign equities than domestic) were implausibly large. This paper reviews the home bias puzzle, theoretical explanations (information asymmetry, hedging demand, regulatory barriers, behavioral), empirical evidence, and the evolution of home bias over time.