Is Your Portfolio Diversified, or Are You Guilty of Home Bias?
In sports, home teams always have the advantage, all else being equal. But unfortunately, the same is not true when it comes to investing. In fact, it’s a dangerous thing to rely on even in sports betting because the sportsbooks that set the lines factor in home-field advantage when doing so.
Home bias in investing is the tendency of equity investors to favor domestic over foreign stocks. It’s significant because it affects how well-diversified a portfolio is. Restricting your investments to a single country leaves you exposed to any market downturns that a country may experience in isolation from the economies of the rest of the world. It also prevents you from taking advantage of international opportunities, especially those offered by emerging economies where growth can be exponential under the right circumstances.
Home Bias in Equities
Understandably, American or Chinese investors exhibit a degree of home bias—they live in the world's two largest economies. But home bias is just as prevalent in other countries that don’t feature particularly thriving economies, even though globalization has made it possible for investors to cast their nets more widely.
A 2012 study explored home bias between 2001 and 2010 in four countries: the US, the UK, Australia, and Canada. Its findings show just how extreme home bias can be even in an economic powerhouse like the US.
In all four countries, domestic overweighting improved slightly over the period studied. For example, in December 2001, American investors, on average, held approximately 34 percent more US stocks than the US market capitalization. By 2010, this had decreased to 29 percent, while the US' domestic market as a percentage of the world market had shifted from 54 percent to 43 percent. In the UK, investors decreased their overweighting to market capitalization from 62 percent in 2001 to 42 percent in 2010. At the same time, the UK's domestic market dropped from 10 percent to 8 percent.
In Australia, whose market as a percentage of the world market was a mere 1 percent in 2001, investors were overweighted in domestic stock by 81 percent. By 2010, Australian stocks made up 3 percent of the world market, and investors overweighted by 70 percent. Likewise, Canada's percentage of the world market grew from 2 percent to 5 percent from 2001 to 2010, and investors overweighting in domestic stocks went from 64 percent to 60 percent.
The authors attribute the decline in equity home bias to increased access to international investment products, improved understanding of international diversification, and lower costs.
Home Bias in Fixed Income
The Philips study also looked at home bias in domestic fixed income. Again, findings proved what is commonly known to be the case—that home bias for fixed income is generally higher than for stocks.
Australian and Canadian investors decreased their home bias marginally in fixed income over the period studied. But American and British investors increased their home bias in fixed income while simultaneously becoming more globally diversified in equity.
The authors point out that the US' increase in fixed income home bias was more a function of the US' fixed income market capitalization as a percentage of the world market cap, which decreased faster from 46 percent to 31 percent between 2001 and 2010. They also comment that home bias in fixed-income products may contain some logic, for example, in the case of defined benefit pension funds.
Drivers of Home Bias in Equity Investing
While there has been a marginal decline in home bias, it remains a consistent and material feature of most portfolios. So, what are the factors driving this phenomenon that investors can look out for?
The Known vs. the Unknown
The primary driver of bias seems to be familiarity—investors believe they know more about companies headquartered in their own countries. This may be valid in the case of countries that have a poor record of transparency, governance, and weak financial reporting standards. However, portfolio managers who work in foreign stocks incur additional expenses to research foreign companies and economies.
Some investors have a policy of supporting domestic businesses out of a sense of national loyalty.
Foreign Currency Fluctuations
Foreign investing involves dealing with foreign currency exchange risks. This places additional risk and complexity on transactions and planning. As a result, some investors may shy away, thinking they lack adequate knowledge. However, it involves a relatively minimal overhead.
Higher Transaction Costs
The US equity market is one of the most widely traded, and therefore liquid, markets globally. As a result, transaction costs tend to be lower than in other countries, especially those that tax transactions. Recently, however, domestic ETFs have considerably reduced the transaction costs of foreign investing.
Undeveloped economies are often characterized by political instability. Investors may be justifiably nervous of companies based in regions where they could potentially be subject to nationalization or where political unrest could shut down stock markets and restrict access to assets.
Forewarned is forearmed, as the saying goes. Where investors educate themselves about home country bias, they can take steps to mitigate their own unconscious biases.