Domestic versus international portfolio selection: a statistical examination of the home bias

The observed international home bias has traditionally been viewed as an anomaly. This paper provides statistical evidence contrary to this view within a mean-variance framework. Two methods of estimating the expected return and covariance parameters are investigated: (i) the traditional Markowitz approach, and (ii) the Bayes-Stein "shrinkage" algorithm. In-sample tests reveal that neither the Markowitz tangency allocation vectors nor the Bayes-Stein tangency allocation vectors are significantly different than a 100% domestic allocation (i.e. extreme home bias). These results are robust to the shorting of equity and across foreign exchange hedge strategies. The paper also reports out-of-sample tests with a view toward investment performance. Typically, a 100% domestic allocation outperforms both the Bayes-Stein and Markowitz tangency portfolios. Overall, the theorized gains to international diversification appear difficult to capture in practice and, hence, investors exhibiting a strong home bias are not necessarily acting irrationally.