Individual investors tend to invest in stocks that are headquartered close to their home, a pattern called ‘home bias’. For example, investors disproportionately invest in local stocks (and in their home countries and home states), which generates an undiversified portfolio and concentrates risk rather than spreading it out.

Worse yet, many investors often invest in their own company stock, exposing them to a dangerous scenario of losing both labor income and stock market wealth if their company suffers financial distress. It is typical the employees’ tendency to own their employers’ stocks in their retirement accounts.

The psychological mechanisms that generate home bias are not precisely known. Several likely mechanisms might be implied:

  • an aversion to ambiguity (called also uncertainty aversion). The investor would prefer known risks over unknown risks
  • preference for familiar “items” (stocks in this case)
  • and a desire to ‘keep up with the neighbors”stock returns (keeping up with the Joneses)
  • Foreign currency exchange risk: Investing in foreign equities necessarily involves foreign currency exchange risk. But this could be even a benefit for diversifying not only the portfolio, but also the currencies of the portfolio.