How much foreign stocks? : Bayesian approaches to asset allocation can explain the home bias of US investors

  • US investors hold much less foreign stocks than mean/variance analysis applied to historical data predicts. In this article, we investigate whether this home bias can be explained by Bayesian approaches to international asset allocation. In contrast to mean/variance analysis, Bayesian approaches employ different techniques for obtaining the set of expected returns. They shrink sample means towards a reference point that is inferred from economic theory. We also show that one of the Bayesian approaches leads to the same implications for asset allocation as mean-variance/tracking error criterion. In both cases, the optimal portfolio is a combination the market portfolio and the mean/variance efficient portfolio with the highest Sharpe ratio. Applying the Bayesian approaches to the subject of international diversification, we find that substantial home bias can be explained when a US investor has a strong belief in the global mean/variance efficiency of the US market portfolio and when he has a high regret aversion falling behind the US market portfolio. We also find that the current level of home bias can justified whenever regret aversion is significantly higher than risk aversion. Finally, we compare the Bayesian approaches to mean/variance analysis in an empirical out-ofsample study. The Bayesian approaches prove to be superior to mean/variance optimized portfolios in terms of higher risk-adjusted performance and lower turnover. However, they not systematically outperform the US market portfolio or the minimum-variance portfolio.

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Author:Ulf HeroldGND, Raimond MaurerORCiDGND
Parent Title (English):EFA 2003 Annual Conference Paper ; No. 207
Document Type:Conference Proceeding
Year of Completion:2003
Year of first Publication:2003
Publishing Institution:Universit├Ątsbibliothek Johann Christian Senckenberg
Release Date:2005/10/07
Tag:Bayesian inference; Portfolio selection; asset-pricing models; estimation risk; international diversification
Issue:April 2002, Revised January 2003
Page Number:31
First Page:1
Last Page:29
Source:EFA 2003 Annual Conference Paper No. 207, Version: Januar 2003, first April 2002
Institutes:Wirtschaftswissenschaften / Wirtschaftswissenschaften
Wissenschaftliche Zentren und koordinierte Programme / Sustainable Architecture for Finance in Europe (SAFE)
Dewey Decimal Classification:3 Sozialwissenschaften / 33 Wirtschaft / 330 Wirtschaft
Licence (German):License LogoDeutsches Urheberrecht