Home-field Advantage: Understanding Domestic Investment Biases in a Globalizing Economy
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By Nicolas Garza
Abundance of choice is a recurring theme throughout many facets of modern life. As computational automation enabled access to more data than could ever be consumed, the constraint of information accessibility that had closely accompanied humankind throughout history vanished. For global financial markets, this frontier was conquered in 1971 with the introduction of NASDAQ, the first platform in the world that allowed investors to access security information and perform trades electronically. However, with this expansion in investment possibilities, deciding to invest in a particular security increasingly meant neglecting countless other alternatives. Through this era of plentiful opportunities, investors’ attention was cemented as a valuable mechanism that provided access to capital.
The relationship between the way investors allocate their attention and how they distribute their capital introduces an additional dimension to financial markets that identifies a two-way street between both phenomena. Although investors are commonly presented as agents that respond to economic developments across the world, the inverse is also true. Investors’ attention influences economic developments through the allocation of capital across markets. In this framing, global financial markets seem to depend not only on asset prices but on the process of investment discovery. This imperfect human mechanism introduces the possibility of investors being predisposed to opportunities that resonate with them on a level that transcends financial data.
Research indicates that investors across developed and emerging economies tend to favor investments within their home countries. Investors in all 22 economies analyzed showcase this effect, known as “home bias,” which can hinder the detection of opportunities and contribute to suboptimal investment decisions. Certainly, international investments operate with significant differences concerning tax implications, currency risk, tariffs, and other material factors in contrast to comparable local transactions. However, the definition of “home bias” is not the summation of the expected frictions pertaining to international investment operations, as those described previously, as it would be unreasonable to expect a state of total efficiency among differing financial environments. These cross-border fiscal requirements represent concrete variables in the analysis of any international opportunity, and their calculation is straightforward–albeit not simple. However, the presence of “home bias” more accurately refers to the disproportionate perceptions of risk stemming from these factors, leading to a failure to objectively assess a security’s potential or even classify it as an investment opportunity.
The observed tendency to invest locally exists in conjunction with other significant barriers to international investment which have not been eroded by globalization. Factors that affect the investment discovery process, such as the existence of a shared language or the geographical distance between economies, also influence the flow of international investment. Research indicates that English-speaking countries receive approximately twice the coverage by investors based in the United States compared to economies whose primary language is not English. Consequently, if investor attention can influence asset prices, does the lack of coverage imply that assets of non-English speaking countries trade at a discount because of language? The potential inaccuracy of the investment discovery process is highlighted by these results, which can ultimately hinder investors’ performance.
Foreign Direct Investment in the United States Relative to Gross Domestic Product. Data sourced from FRED, Federal Reserve Bank of St. Louis.
Interpreting foreign direct investment as a gauge for the level of interconnection between economies exhibits the increasing long-term trend of international corporate ownership. Although the measure presented above is limited to foreign investment within the United States, FDI has followed a similar trend throughout developed and emerging economies during the same period. However, FDI’s continued growth has not eroded the tendency for investors’ portfolios to concentrate on domestically issued financial instruments. Acknowledging the disproportionate effects that non-financial factors, such as language and geographical distance, can have on investors’ decisions becomes increasingly important as economies become more intertwined.
Although the phenomenon of “home bias” has been primarily detected in public equity and debt markets, possibly because of an abundance of publicly available data in the sector, it is plausible to assume that it could also be present in other asset classes, including venture capital, private equity, and government-issued debt. This would imply the presence of inefficiencies throughout a broader investment landscape than research originally suggested. In asset classes where the volume of transactions is lower and whose details are mostly unavailable to other investors, the effect of “home bias” could be more pronounced due to a lack of comparable operations to guide the expected value of the transaction.
Incorporating the behavioral evidence of the existing preferences for locally issued financial instruments into decision-making processes can lead to a more holistic perspective on international investment, guiding investors toward the discovery of attractive opportunities through the awareness of such cognitive pitfalls. Increasing the diversity of perspectives during the investment discovery process can also allow for the recognition of a broader set of investment possibilities, closing the gaps between geographical and linguistic differences. Similarly, establishing a continuously more accurate model for the conduct of international investment beyond financial data can provide orientation for policymakers while addressing the regulatory forces impacting cross-border investments.
Nicolas Garza is a junior at New York University from Monterrey, Mexico studying economics and computer science. He is interested in business economics and international finance. In his free time he enjoys running through Hudson River Park.
