The puzzle of ‘home bias’ in investing
by Shivaji Das/DNA Money
'Home bias' is a persistent and major puzzle in international finance. Studies have discovered that foreign equities account for a small proportion of investor's portfolio's in developed nations.
This is clearly puzzling since it seems that investors are shying away from chances to diversify their risk. However, a step in the unravelling of this puzzle has been offered from the field of neuroscience.
In a paper published in last week's Science, researchers led by Ming Hsu and Meghana Bhatt from California Institute of Technology, Pasadena, give us some idea of how the brain behaves when faced with risky choices—choices where the probabilities are clearly known such as investing in local stocks and ambiguous choices where the lack of information 'seems' to disallow one from having an idea of the odds.
The difference between risk and ambiguity is shown easily enough.
For example, imagine you have two decks of 100 cards each. The first deck has 50 blue cards and 50 red cards, while the second deck has the same two colours but in an unknown distribution. A card is picked randomly from both the decks.
Would you bet on the colour of the card from first deck or the second? The first deck signifies risk - you know the probabilities, the second deck signifies ambiguity - it may be possible that all the cards in that deck are of the same colour. Studies have found that people are far more willing to bet on risky outcomes than on ambiguous ones.
However, in the view of subjective probability theory, on which a lot of current risk aversion theories are based, there is no reason to choose the first deck over the other and therefore it should not affect your decision.
Why? Because as long as you are unbiased against the two options — red or blue — you are equally likely to say either, whatever the distribution of the colour in the pack. Hence, even if all the cards are of the same colour, you still only have a 50% chance of betting correctly. In the study, scientists monitored the brains of several volunteers who were given various decisional tasks to do. They found that when faced with an ambiguous choice and shortly before any choice was made, the emotional areas of the brain would become very active.
Moreover, the part of the brain that anticipates reward would become less active. It seemed that in the face of ambiguous choices, the heart was telling the individual what to do and at the same time the brain was bracing itself for a loss. This could be a possible explanation for the 'home bias': though logic dictates that we should be unbiased - that we should not distinguish between the two decks, in normal circumstances, we cannot help but act the way we do. Standard theories do not take into account that a person's brain behaves differently in the face of risk and ambiguity. "There is much more to risk aversion than decreasing marginal utility," explained Bhatt.
The study also found that people having lesions in the emotional areas of the brain in question (the amygdala and the orbitofrontal cortex) treat risky and ambiguous cases as the same and thus their abnormal behaviour is ironically consistent with subjective expected utility theory. Explaining the practical consequence of her work, Bhatt said, "The reluctance to hold foreign stocks amounts to a sacrifice in annual percentage return of one to two per cent per year, according to one estimate. Assuming an average unbiased return of 7%, a person with home bias who invests a lump sum at age 25 will end up with only half as much money at age 65 as an unbiased investor. It is nearly impossible to tease apart theories offered to explain home bias using field data alone. Our approach has the potential to differentiate among the possible explanations."
Mind over matter
Research paper shows how brains behave when confronted by risky choices
Though logic dictates that we should be unbiased, we're hardly so
When faced with ambiguous choices, emotions get the upper hand
