Behavioral Finance Home Market Bias

1. Behavioral Finance Home Market Bias

2. Experiment • Box A contains 10 balls. There are 5 yellow balls and 5 white balls. • Box B contains 10 balls. There are two kinds of balls, yellow or white. But, you do not know how many yellow/white balls are in the box. • 1. You need to choose between Box A or Box B to draw a ball. If the ball drawn is yellow, you will receive $5, zero otherwise. Which box will you choose? Box A Box B

3. Experiment • 2. You need to choose between Box A or Box B to draw a ball. If the ball drawn is white, you will receive $5, zero otherwise. Box A Box B

4. Experimental Results • Q1 • Proportion choosing Box A: • Q2 • Proporiton Choosing Box B:

5. Ellsberg Paradox Urn 1: Risk 5 Green 5 Red Most people indifferent between betting on Red versus Green

6. Ellsberg Paradox Urn 2: Ambiguity X Green 10-X Red Most people indifferent between betting on Red versus Green

7. Ellsberg Paradox Urn 1: Risk Urn 2: Ambiguity Most people prefer betting on urn 1 versus urn 2

8. Ellsberg Paradox Urn 1: Risk Urn 2: Ambiguity P(Red1)=P(Green1) P(Red1)=0.5 P(Green1)=0.5 P(Red2)=P(Green2) P(Red2)<0.5 P(Green2)<0.5

9. Knight and Keynes’s Insights in 1921 Knight “If two probabilities are equal in degree,ought we, in choosing our course of action, to prefer that one which is based on a greater body of knowledge?" Keynes measurable uncertainty or riskunmeasurable uncertainty

10. Home bias • Domestic investors hold mostly domestic securities. • American investors hold mostly U.S. securities • Japanese investors hold mostly Japanese securities. • British investors hold mostly U.K. securities. • In so doing they forego gains from international diversification.

11. Investor international holdings Source: French, K. R., and J. M. Poterba, 1991, "Investor diversification and international equity markets," American Economic Review 81, 222-26.

12. Potential home bias explanations • Excessive optimism about prospects of domestic market. • Comfort-seeking and familiarity. • What is familiar is good (i.e., a good investment) • Institutional restrictions: • Capital movement restrictions • Differential trading costs • Differential tax rates • Latter likely plays a very minor role. • Source Preference • Choice between prospects depend not only on the degree of uncertainty but also the source of uncertainty (e.g., Beijing temperature versus Paris temperature)

13. Excessive domestic optimism would imply a lot of disagreement among investor groups Source: French, K. R., and J. M. Poterba, 1991, "Investor diversification and international equity markets," American Economic Review 81, 222-26.

14. Home bias within a country • Home bias seems to be driven by a comfort-level with the familiar. • In 1984, AT&T was forced by the court into a divestiture whereby seven “Baby Bells” were created. • Created along regional lines – example: Bellsouth serving southeastern United States.

15. Familiarity and home bias • If people like familiarity, then we would expect that a disproportionate number of a Baby Bell’s customers to hold a disproportionate number of shares in the same Baby Bell. • Exactly what happened after the divestiture.

16. Poor diversification is implied • From diversification standpoint, if anything you are wise to underweight (not overweight) local companies. • If you work and invest locally, technically speaking, your two income sources are highly correlated. • Diversification theory says you should look for income streams that are weakly correlated. • Better for investors to buy stock in Baby Bells outside their region.

17. Language • In Finland, there are two official languages, Finnish and Swedish. • Annual reports are normally published in Finnish or in both official languages, but in a few cases reports are only published in Swedish. • Controlling for other relevant factors, Finnish investors prefer companies whose language of publication is Finnish. • And Swedish investors prefer companies whose language is Swedish – with bilingual companies being mid-ranked.

18. Culture • From the same study, culture matters as well. • It was noted whether CEOs were Finnish or Swedish. • Controlling for language of the company, Finnish speakers prefer Finnish CEOs. • And Swedish speakers prefer Swedish CEOs.

19. Home bias and informational advantage • A rational explanation for local preference is informational advantage. • You know more about what is close. • Gains from being local to a company may appear in improved monitoring capability and access to private information.

20. Source Preference • Source preference: Choice between prospects depend not only on the degree of uncertainty but also the source of uncertainty (e.g., Beijing temperature versus Paris temperature)

21. Source Preference Experiment 1. Please choose between betting on whether the last digit of the stock price of LVMH (listed in French Stock Exchange) /CLP (Listed in HK Stock Exchange ) in the next trading day is odd or even.

22. Source Preference Experiment 1. Please choose between betting on whether the last digit of the stock price of LVMH (listed in French Stock Exchange) /CLP (Listed in HK Stock Exchange ) in the next trading day is up.

23. Source Preference Experiment 1. Please choose between betting on whether the last digit of the stock price of LVMH (listed in French Stock Exchange) /CLP (Listed in HK Stock Exchange ) in the next trading day is down.

24. Experimental Results

25. Fox and Tversky

26. Fox and Tversky In the comparative condition subjects were willing to pay $15.84 more to bet on familiar San Francisco temperature than on unfamiliar Istanbul temperature.

28. Evidence from mutual fund manager behavior • Consistent with familiarity bias, managers tend to favor local firms. • Average manager invests in companies that are 160-84 kilometers, or 9-11%, closer to her than the average firm she could have held. • Local preference is related to firm size: tendency to invest locally stronger for smaller firms (where informational advantage is likely to be greater).

29. Does local preference boost performance? • Significant payoff to local preference. • Fund managers on average earn 2.67%/year more on local investments. • While local stocks avoided by managers underperform by 3%/year. • And those better able to select local stocks tend to concentrate their holdings more locally.

30. Can retail investors profit from local information? • Evidence that retail investors also have some ability in this regard. • Reminiscent of money manager finding, based on a dataset of retail investors, local investments outperformed remote investments by 3.2%/year.

31. Summary • Choice under risk vs. uncertainty • Ambiguity aversion • Home market bias