The Home Bias in Investment
Submitting InstitutionLondon Business School
Unit of AssessmentBusiness and Management Studies
Summary Impact TypeEconomic
Research Subject Area(s)
Economics: Applied Economics, Econometrics
Commerce, Management, Tourism and Services: Banking, Finance and Investment
Summary of the impact
The home bias is the observation that investors systematically
hold far too many domestic assets, and consequently far too few foreign
assets, than is justified by economic models. Ian Cooper, Evi Kaplanis,
Richard Portes, and Heĺene ` Rey, developed the theory of and evidence for
the home bias phenomenon. This research has had a substantial impact
on investment managers (via additional value from increasing the global
diversification of their portfolios), and on central banks and
regulators (via accounting for the excessive concentration in domestic
This research was carried out at London Business School, with research
outputs published over the period 1994 to 2005. Cooper and Portes held
appointments throughout and do so now; Kaplanis was at LBS at the time
the research was conducted. (Heĺene ` Rey joined LBS more recently.)
Home bias is the phenomenon whereby investors hold significantly
too much of their wealth in assets that are based in their home country,
as opposed to assets from other countries. The phrase too much is
unequivocal because it can be demonstrated that they could earn higher
returns, but carry the same overall portfolio risk, by investing more of
their money abroad.
LBS finance researchers Ian Cooper and Evi Kaplanis devised a simple way
of calibrating the home bias so that the rationality or otherwise of
portfolios can be tested. They also demonstrated that one important
proposed explanation, that investors hold domestic assets in order to
hedge inflation risk, is incorrect. They then devised a technique to
quantify the loss to investors from in-adequate international
diversification, by inverting the investor portfolio holdings to get the
implied costs that would justify the level of equity home bias. They
showed that this is greater than any actual observable cost and is
inconsistent with the motive of hedging inflation. LBS economists Richard
Portes and Heĺene` Rey used a new, large database on cross-border equity
transactions to examine how geography affects investment. They used
telephone-call traffic and multinational bank branches to account for
information transmission. They demonstrated that this explains a very
large fraction of cross-border investment flows. They also (with co-author
Yonghyup Oh) showed that the degree of home bias was different across
asset classes (government bonds, corporate bonds, equities) and depended
on the degree of information intensity required to trade in those
different assets. Information variables explain much more than the motives
ascribed by traditional finance theory, such as diversification. Their
papers showed that a gravity model is at least as good at
predicting international asset trade as it is for goods trade.
References to the research
"Home Bias in Equity Portfolios, Inflation Hedging, and International
Capital Market Equilibrium," Ian Cooper and Evi Kaplanis, Review of
Financial Studies, 7(1), 1994, pp. 45-60.
"Home Bias in Equity Portfolios and the Cost of Capital for Multinational
Firms," Ian Cooper and Evi Kaplanis, Journal of Applied Corporate
Finance, 8(3), 1995, pp. 95-102.
"The Implications of Home Bias in Equity Portfolios," Ian Cooper and Evi
Kaplanis, Business Strat-egy Review, 5(2), 1994, pp. 41-53.
"The Determinants of Cross-Border Equity Flows," Richard Portes and
Heĺene ` Rey, Journal of International Economics, 65(2), 2005,
pp. 269-296. dx.doi.org/10.1016/j.jinteco.2004.05.002.
"Information and Capital Flows: The Determinants of Transactions in
Financial Assets," Richard Portes, Heĺene` Rey and Yonghyup Oh, European
Economic Review, 45(4-6), May 2001, pp. 783-796.
Evidence of quality. The outputs are published in leading general
interest (European Economic Review), finance (Review of
Financial Studies), and international economics (Journal of
International Economics) journals; these are rated as 3? or
4? by the ESRCRES benchmarking review of UK Economics. All outputs
have been cited extensively: almost 2000 "google scholar" citations.
Details of the impact
Beneficiaries. There are two main groups of beneficiaries of the
research: firstly, investment managers; and, secondly (and especially)
central bankers and other regulators.
Nature of the impact. Firstly, the research has had an impact on
investment managers because it has demonstrated the additional value they
can obtain by increasing the global diversification of their portfolios.
In response to this growing awareness over the past decade, investment
portfolios held by pension funds and other investors have become greatly
Secondly, central banks and regulators have been significantly impacted
because home bias determines the need for regulation and intervention,
and the kind of regulation and intervention that are optimal. For example,
the European Central Bank needs to account for the fact that most banks
hold portfolios that are heavily concentrated on their own countries'
government debt. Hence default, write-downs, and price falls caused by
market concerns about sovereign creditworthiness have a magnified impact.
The research has very wide reach because all central bankers need to take
account of international linkages in designing regulations and
Impact process (i): the academic channel. The impact flows through
the research of other academics. The reason for this is that the
Cooper-Kaplanis (1994) and Portes-Rey (2005; originally 1998) papers are
foundation pieces: jointly they have received almost 2000 "google scholar"
cites. These papers have substantially changed the academic literature;
this has, indirectly as well as directly (there is specific evidence for
direct impact) changed the understanding of the impact beneficiaries;
and this new understanding has resulted in the impact. Cooper and Kaplanis
(1994) was the first to test inflation hedging as the explanation for home
bias, and also developed a method for inverting portfolio holdings to
measure the implicit opportunity cost of home bias. Portes and Rey (2005;
1998) was the first empirical explanation for the equity home bias and the
first to use information variables to test information flows as the
As further evidence of the reach of Portes-Rey, Yohei and van Wincoop
("Gravity in International Finance," Journal of International Economics,
2012) said: "The past decade has witnessed an explosion of papers
estimating gravity equations for cross-border financial holdings. This
used to be the territory of the international trade literature . . . at
least three factors are driving this interest in estimating gravity
equations applied to international finance. One is the discovery that
gravity equations for international asset trade explain the data at least
as well as for goods trade. The contribution by Portes and Rey (2005)
is central in this regard. . . . there is a wealth of potential
policy questions that can be addressed through the estimation of gravity
equations . . . "
Impact process (ii): the final impact on beneficiaries. The work
has important implications for practitioners who take crucial decisions
in international portfolio investment and international corporate finance.
There are two specific impacts: it has contributed to greater
international diversification by portfolio managers; and it changes the
way central bankers design regulations and interventions.
The significance of the research for investment managers is reflected in
the switch to more diversified portfolios. This impact has occurred
through the channel of practitioners making direct use of their research
articles (evidence is provided in the corroboration sources) and also by
the research filtering into other researchers' work.
As an illustration, a senior investment manager is quoted in the
Financial Times of June 12, 2011 on the growing awareness of the costs of
home bias: "Alan Brown, chief investment officer with Schroders, contends
that intellectually, it is almost impossible to justify favouring your
country's stock market. `Its hard to explain why you would want to invest
in such a narrow opportunity set," he says. He thinks home bias is far
less prevalent than it was a decade or two ago . . . '
The use of gravity models in international finance has become a
significant tool used by central bankers including staff at the Federal
Reserve Board and Banks, the ECB, and the IMF. For example, Hellerstein
and Ryan (NY Fed) used a gravity model to estimate US dollar cash flows; a
paper by the principal economist at the ECB Directorate General
International and two colleagues (Chit¸u, Eichengreen, and Mehl) used a
gravity model to explain foreign bond holdings; and the IMF research
bulletin contains an article explaining how gravity models are used to
explain foreign direct investment flows. (References are provided in the
Although investors responded by diversifying investments more than they
used to, home bias still exists and affects the way central bankers and
other regulators form policy. For example, Jens Weidmann, president of the
Bundesbank, writing in the Financial Times, described how banks "invest in
government bonds and the `home bias' of buying the local sovereign's debt
has increased during the crisis. Because such debt can usually be lodged
as collateral at the ECB in return for cheap funding, exposure to
government bonds of countries like Spain and Italy is even more attractive
since the debt now also yields more."
Sources to corroborate the impact
An important corroboration source is the direct knowledge and use of the
research by practitioners and policymakers. We have provided (the maximum)
five senior sources who will corroborate:
- Assistant Director of the Research Department of the International
- Deputy Director of the Research Department of the European Central
- Vice President for Financial Intermediation, Federal Reserve Bank of
- Head of Research, Private Banking and Asset Management, Credit Suisse.
- Global Chief Economist, Citigroup.
Links to quoted Financial Times articles.
Papers from Deutsche Bundesbank, ECB, Federal Reserve, and IMF.
"Portfolio Holdings in the Euro Area: Home Bias and the Role of
International, Domestic and Sector-Specific Factors," Axel Jochem and Ute
Volz, Deutsche Bundesbank, July 2011.
"The Pecking Order of Cross-Border Investment," Christian Daude and
Marcel Fratzscher, Journal of International Economics, 74(1),
January 2008, pp. 94-119.
"History, Gravity, and International Finance," Livai Chit¸u, Barry
Eichengreen, and Arnaud Mehl, ECB Working Paper No. 1466, September 2012.
"Decomposing the US External Returns Differential," Stephanie E. Curcuru,
Tomas Dvorak, Francis E. Warnock, Journal of International Economics,
80(1), January 2010, pp. 22-32.
"Cash Dollars Abroad," Rebecca Hellerstein and William Ryan, Federal
Reserve Bank of New York Staff Report no. 400. www.newyorkfed.org/research/staffreports/sr400.pdf
"International Investment Patterns," Philip R. Lane and Gian Maria
Milesi-Ferretti, Review of Economics and Statistics, 90(3),
August 2008, pp. 538-549. DOI: 10.1162/rest.90.3.538 IMF Research Bulletin
9(1), March 2008. www.imf.org/external/pubs/ft/irb/2008/01/index.pdf