‘Home Bias’ Phenomenon Challenge the View That Investors Are Rational

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IA183
Assignment Writing Skills for AFM Studies
USC2012

To what extent does the ‘home bias’ phenomenon challenge the view that investors are rational?

Student:Zhuang, Yuanxun
Tutor: Alexander Bedborough
Date:16th November 2012
Word Count: 726

This essay will explain what rationality of investors and home bias are and then discuss to what extent the ‘home bias’ phenomenon challenges the view that investors are rational.

In neoclassical economics, investors are supposed to be rational, which includes 3 points(assumption)?, 1) “people have rational preferences across possible outcomes or states of nature”; 2) “people maximize utility and firms maximize profits”; and 3) “people make independent decisions based on all relevant information”(Ackert& Deaves 2010, p.4). These points here are supposed to judge whether investors are rational or not in this essay.

Home bias phenomenon might probably challenge the view that investors are rational. Home bias is the tendency of investors to invest in a large amount of domestic equities, despite the potential benefits of diversified foreign equities (Tesa & Werner, 1995). If investors are rational, investors should look for diversification of portfolio in international markets because it has been recognized for a long time that potential profits can be gained by the diversification of investment portfolios across national markets (Tesa & Werner, 1995). But as French & Poterba(1991) show, most investors hold nearly all of their wealth in domestic. In the five biggest stock markets of the world, 92.2 percent of ownership in USA stock market is hold by domestic investors, 95.7 percent in Japan, 92 percent in United Kingdom, 89.4 percent in France, and 79 percent in Germany. This shows “home bias” phenomenon heavily exists.

To some extent, investors are supposed to be not totally rational. Rational investors should invest for highest profit and comparative lowest risk according to the...
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