Do you prefer to bet on the decrease of the Dow Jones or the CAC40 on the first of next September?
These questions have been asked in many experiments on behavioral finance to MBA students or financial professionals and answers are always similar. If you are American, you may prefer, in both cases, to bet on the increase or decrease of the Dow Jones while if you are French you will contrarily bet on the increase and decrease of the CAC40, here is an issue, right?
Home bias is a cognitive bias that makes us prefer to invest in something we know, even if it is not the most optimal investment to make. This bias has been particularly studied for its impact on financial markets and its mechanisms are still not very well understood.
Home bias has also been studied and modelled by behavioral economists using a Prospect Theory framework. Based on this framework, we first evaluate the probability of success of our investment, objectively if the probability is given by a statistical model or subjectively if we have no tools to estimate it. Then, our biased brain automatically transforms this probability via a weighting function which depends on how familiar we are with the source of the investment, among many other factors.
Let’s be more concrete by looking at a simple example. Let’s assume we are all French (if you are not, don’t worry, it won’t last long!) and that we are invited to bet on the increase or decrease in temperature on a given date in France and abroad. We all make our own subjective evaluation of this temperature. Then, we will automatically transform this probability based on how familiar we are with the geographical location. In other words, we will be more optimistic, and take more risk, if we have to bet on the France weather than on the foreign temperature. A recent experiment by Abdellaoui and al. has measured among business students this ”home bias” whose results are shown below.
Prospect Theory, for risk and ambiguity, Wakker (2011)
Coeurdacier, N., & Gourinchas, P. O. (2011). When bonds matter: home bias in goods and assets (No. w17560). National Bureau of Economic Research.
Abdellaoui, M., Baillon, A., Placido, L., & Wakker, P. (2009). The rich domain of uncertainty. American Economic Review.Psychology of investing, John Nofsinger, 2004
Coval, J. D., & Moskowitz, T. J. (1999). Home bias at home: Local equity preference in domestic portfolios. The Journal of Finance, 54(6), 2045-2073.