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Investment Anomalies: The Home Bias Puzzle

October 31, 2010 1 comment

“Home is a name, a word, it is a strong one; stronger than magicians ever spoke, or spirits ever answered to, in the strongest conjuration” (Charles Dickens). From a very early stage in life, individuals are bombarded with the constant theme of unity; the sense of belonging to a group. This theme manifests itself in our institutional structures: families, schools, places of employment, and on a grander scale, nations. Perhaps the theme is best captured in Aesop’s famous tale, where a father shows his children that, it is only when you gather separate sticks in a bundle, does it become hard to break them. War generals know this all too well, as their strategies always pivot on the concept of divide and conquer. This theme, which stems from our tribal ancestral times, did prove successful on countless occasions; though it does have its shortcomings. Albert Einstein once noted that “nationalism is an infantile disease. It is the measles of mankind”.

If we may narrow our perspective to a more investment oriented one, it may be argued that such a theme did inject itself in the investment field, as observed by investors’ portfolio compositions. “Investors appear to invest only in their home country, virtually ignoring foreign opportunities” (Coval ad Moskowitz, 1999). This phenomenon is dubbed the home bias puzzle. In theory, it is assumed that investors are looking to achieve the highest possible returns, all the while reducing their risks to a minimum. But while achieving such returns, an investor’s portfolio is constrained with restrictions that define the assets they may be added into it. The  various portfolios that may result from the inclusion/exclusion of the different allowable assets, is referred to as the “potential possibility set” (Levy and Post, p. 205, 2005). Such portfolio restrictions are either levied onto the investor or self-imposed; for example: government assets, quotas, or the decision to invest  only in ethical companies. Such restrictions effectively reduce the investor’s potential possibility set, impacting potential diversification; in other words, increasing the potential risks and decreasing the potential returns.

Returning to the home bias puzzle, when investors elect to invest mainly in their home countries, they shrink their potential possibility set, since they are discarding away all the foreign investment opportunities. This of course is bad for the investor, since “the fortunes of different nations do not always move together. Investors can diversify their portfolio by holding assets in several countries” (French and Poterba, 1991); potentially lowering a portfolio’s risk while increasing its returns.

The question of, why would investors limit their potential possibility sets?, was first put forth by French and Poterba. They noticed the home bias puzzle while observing that the domestic “ownership shares of the world’s five largest stock markets [were]: United States, 92.2 percent; Japan, 95.7 percent; United Kingdom, 92 percent; Germany, 79 percent; and France 89.4 percent” (French and Poterba, 1991). The ramification of this home bias is best illustrated through a later study conducted by the Center for European Economic Research, where it was concluded that had the German investors held zero domestic stocks and the UK investors only held 10 percent domestic stocks in their portfolios in the past 20 years, their returns would have risen by “82 per cent and … 54 per cent” (Mawson, 2002) respectively; all other variables held equal. What was more puzzling was that “geographic proximity seems to be an important ingredient in the international portfolio allocation decision” (Tesar and Werner, 1995); in the sense that if an investor does decide to invest internationally, then the probability of investing in companies of neighboring countries was much higher than in companies located further off; even if better returns could be achieved in the further locations. Naturally, the question that complements that of the home bias puzzle was, why should geographic location have precedence over asset returns for an investor?

Various explanations were put forth in answering the above questions, most notable of which were:
> Investor behaviour: as explained in the beginning, an investor might feel that it is their moral duty to promote advancements in their own country, opposed to foreign countries; even if that means earning lower returns. It could also be the case that an investor feels more in control when they are investing in something that they know about; as opposed to something completely foreign to them. Investing locally could also be the result of mimicking the investor’s surrounding peers. Therefore, an investor’s behaviour is most influenced by: nationalism (sense of unity), illusion of control and surrounding peers.
> Information asymmetry: as the idiom goes, knowledge is power, and access to it may be influenced by location. Therefore, “asymmetric information between local and nonlocal investors may drive the preference for geographically proximate investments” (Coval and Moskowitz, 1999).
> Institutional factors: capital immobility may result due to institutional factors, which include: taxes, transaction costs and government quotas.
> Other factors: other risks that could be faced by an investor, which have not been mentioned above, such as: foreign exchange risk, country risk, etc.

Upon analyzing the above arguments, it could be concluded that institutional along with other factors do not play a direct role in explaining the home puzzle theory. The reason for this conclusion is that as markets open up due to globalization, and technologies continually advance, a lot of the factors/costs/risk should have become less influential, and as a result, investor portfolios should have shown an increased portion of foreign shares in their composition. Yet, since the investors’ portfolios are still dominated by domestic shares, then such factors could not possibly shed a complete explanation on the home bias puzzle. Various studies confirm such conclusion. For example, “Tesar-Werner [concluded that] transaction costs cannot explain the observed home bias” (Watnock, 2002). Though it should be noted that such conclusion could one day be open for debate, as more recent studies hint at a possible “indirect relationship” (Watnock, 2002) between institutional factors and the home bias puzzle.

A more sensible explanation of the home bias puzzle, brings together two of the above explanations: investor behaviour and information asymmetry. The explanation, put forth by Van Nieuwerburgh and Veldkamp (2009), classify investors into two types:
> Investors who do not account for the “effect of learning on portfolio choice”:  such investors do not make any correlation between information and returns. Thus, when such investors build their investment portfolio, they are naturally attracted to domestic assets, as they are guided by their instinct behaviour. Therefore, their portfolio will be dominated by domestic assets.
> Investors who take into account information when making investment decisions: such investors will want to “reinforce informational asymmetries. Investors learn more about risks they have an advantage in because they want their information to be very different from what others know”. And thus, such investors believe that they are gaining an advantage over other foreign investors who invest in their local market. This of course is false, since by investing only in domestic assets, these investors are limiting their potential possibility set.

— Youssef Aboul-Naja

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Working Capital: Benefits of the Money Market

March 14, 2010 Leave a comment

In the Beginning: The Balance Sheet

It all starts, when a couple of entities decide to pool their resources together to generate more resources. They do so by creating a company; and they inject it with their pooled resources [known as equity] along with some long-term debt; the combination of equity and long-term debt consitutes the company’s capital strucutre. The company then converts this capital “into assets [and operates it] to earn economic returns by fulfilling customer needs” (Groth and Anderson, 1997).

Thus, we have established that a company has assets financed through equity and long-term debt. The company’s assets are made up of current assets [which are more liquid: in the sense that they can be converted into cash more readily] and fixed assets [which are more illiquid assets: such as factories]. Like wise,  part of the longer-term debt will be short-term (or current liabilities), to enable day to day financing operations. Therefore, we conclude that current and fixed assets are financed with current liabilities, long-term debt and equity; which are the constitutes of the balance sheet. This is captured in the below formula:

Current Assets + Fixed Assets = Current Liabilities + Long-term Debt + Equity   (equation 1)

Working Capital: What Is That?

In a nutshell, “working capital is the [difference] between current assets and current liabilities” (Pass and Pike, 1987). Current liabilities represents the debts or obligations that must be paid by the company within the duration of one year; whereas, current assets are those assets that will be converted into cash within one year. Therefore, working capital represents the supposed excess cash on hand “to continue business operations” (Needles and Powers, 2004, p.259). The importance of this quantity is that it gages a company’s liquidity; the availability of cash to continue operations and meeting debt obligations.

Ideal World View: Working Capital

In an ideal world, the management of a company would be able to identify all the debt obligations it shall incur in the upcoming year. By knowing such information, management would match the current liabilities with the same amount of current assets; effectively having a net working capital of zero. Referring back to (equation 1) from the previous section, since current assets and current liabilities are equal, they can be dropped from the equation. Therefore, in an ideal world, fixed assets (which have a longer nature of usability) would be financed by long-term debt and equity. So we notice that, there is a matching of the “maturity dates of the assets with the liabilities” (Pass and Pike, 1987). This ideal world view is best captured in the below diagram:


Real World View: Working Capital & Money Markets

Though the ideal world view conceptually makes sense, it is flawed for two reasons. The first of which is that it is very hard to predict with certainty the debt obligations for the upcoming year. The second, and more important issue, is that “current assets cannot be expected to drop to zero … [as] long-term rising level of sales will result in some permanent investment in current assets” (Ross et al., 2008, p.755). This permanent investment in current assets comes partially in the form of accounts receivables, inventories, accruals, etc. Therefore, the real world view diagram will look something like:

A company will want to maintain a working capital such that it would minimize the sum of the carrying and shortage costs; it would do so by “minimizing the amount of funds tied up in current assets” (Filbeck and Krueger, 2005). Why a company would do so, is because short-term debt is much cheaper than long-term debt &/or equity, especially since working capital is financed by their of the latter two.  But if a company wants to maintain a set working capital, its must be able to predict accurately future inflow/outflows of transactions (cash); which as previously discussed, not possible. Thus a company might have, at anytime, a bit more or less cash relative to the optimal capital structures, running costs up; as depicted in the below diagram:

(Pass and Pike, 1987)

That’s were the role of the Money Market (MM) comes in. If a company has excess cash, it would invest it in the MM. Likewise, if it requires additional money, it would obtain it from the MM; which is short-term in nature, meaning cheaper than long-term debt or equity. In that regards, the more developed the MM of a given country, the easier it is for companies to obtain short-term finances, and maintain a working capital that would result in the least amount of costs.

~ Youssef Aboul-Naja