Home Sweet Home Investment
Both standard portfolio theory and the composition of commonly used value-weighted world equity indices suggest that investors should hold approximately between 50% 60% in foreign stocks in their portfolios. However, by all existing records and methodologies, investors persistently hold a significantly under-diversified portfolio with holdings in foreign stocks as low as 10%. The quantitative analysis in Ambiguity Aversion and Under-Diversification, an article by Massimo Guidolin (Department of Finance) and Hening Liu (Manchester Business School), forthcoming in the Journal of Financial and Quantitative Analysis, demonstrates that such substantial under-diversification can be explained by the massive uncertainty the average investor would face when making investment decisions.
The impact of uncertainty and ambiguity on investment decisions has received considerable attention by finance researchers over the last few years. Anecdotal evidence suggests that investors' uncertainty about future investment opportunities may help explain the persistent focus on domestic stocks, and the consequent under-diversification plaguing the composition of their portfolios. However, a full-scale quantitative analysis that helps us in understanding the mechanism that maps investors' uncertainty into under-diversification was still missing. The paper published by Guidolin and Liu contributes to filling this gap.
The base hypothesis of the authors is that investment decisions are affected by both the risk implicit in the historical performance of risky assets and the uncertainty that characterize the future evolution of the payoffs. Yet, investors are risk averse in that they dislike any mean-preserving spread of the end-of-period wealth given a portfolio allocation at the beginning of the period. However, investors are also ambiguity averse in the sense that they are averse to any mean-preserving spread of conditional expected utility induced by personal beliefs. In that respect, the compounding effect of risk and ambiguity aversion generates under-diversification and an excessive focus on domestic stocks.
The authors use this approach to study international asset allocation from the perspective of a US investor, who has a prior degree of belief in the global mean-variance efficiency of the US market portfolio. They find that ambiguity aversion can lead to strong home bias in equity holdings, regardless of an investor's belief in the domestic CAPM. More importantly, the authors show that ambiguity aversion persistently generates the degree of international under-diversification that is typically observed in the data, in both bull and bear regimes and also regardless of the degree of the investor's faith in the global mean-variance efficiency of the domestic market portfolio.
These results point decisively to the role of uncertainty on investment decision making processes. As such, a tentative to reduce global uncertainty, and the sensitivity of investors to such uncertainty, might help to lead investors towards more diversified and hence stable portfolios.