| Portfolio theory suggests that international diversification increases returns and decreases risk. Consequently, investors should diversify their portfolios across international markets. In practice, however, investors hold globally under-diversified portfolios. This study examines a novel cause of US-based institutional investors' foreign portfolio deviations from perfect diversification. We attribute the deviation to cultural similarity between the locales in which the US financial institutions operate and the foreign countries in which they invest. Specifically, we measure cultural similarity between each US institutional investor's local market and every possible investment option outside the US, directly based on 2010 US Census and the ethnicity of the foreign markets. We show that portfolio allocation increases with higher cultural similarity in US states and zip codes and foreign markets. We also show that higher cultural proximity can increase performance in foreign investments. |
