NCPA - National Center for Policy Analysis


January 18, 2007

Numerous studies have established that investors are biased against foreign securities and tend to undervalue them when assembling their portfolios.  In their study, researchers Fang Cai and Francis Warnock show that if the basis for defining a "foreign" firm is changed from the location of the firm's headquarters to the locations of its operations, the home bias seen in many studies is reduced considerably.  In fact, Cai and Warnock show that institutional investors overweight domestic multinationals (MNCs) relative to purely local domestic firms.  That is, such investors exhibit a bias in favor of the domestic firms that may provide the greatest international diversification benefits.

This is significant in that evidence for investors' diversification motives is hard to come by.  It is generally accepted that investors overweight the familiar (domestic securities) at the expense of less familiar (foreign securities):

  • Even within their foreign portfolios, investors seem to prefer the stocks of foreign countries that are closer and whose equity markets are most nearly correlated with their own; within foreign countries, investors prefer large, familiar stocks.
  • Even within their domestic portfolios, investors much prefer the familiar and tend to avoid stocks that are less correlated with the rest of their portfolios -- exactly those stocks that would provide the greatest diversification benefits.

Cai and Warnock's study reaffirms that investors favor the familiar:

  • Their evidence reveals that foreign investors overweight large firms, those that trade the most, and those with foreign operations -- in other words, firms with the highest profiles.
  • Most importantly, the authors find evidence of the international diversification motive; they find that domestic institutional investors show a decided preference for domestic multinationals.
  • Even after controlling for familiarity, size, inclusion in major indexes, product tradability and turnover, Cai and Warnock find that the bias for domestic firms with overseas operations remains.

Source: Matt Nesvisky, "Global Diversification Through Multinational Shares," NBER Digest, January 2007; based upon: Fang Cai and Francis E. Warnock, "International Diversification at Home and Abroad," National Bureau of Economic Research, Working Paper No. 12220, May 2006.

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