Why home bias could be holding your investments back
Is there really no place like home when it comes to investing? Many investors might feel tempted to favour their home market, or local markets. It seems natural, after all – sticking to what’s familiar; you feel in control.
Yet, if you invest too heavily in one area you risk losing out on the well-established benefits of diversification.
Over-exposed to your home market?
A common finding is that investors tend to over-invest in their home market due to a preference for domestic equities, and/or a concentrated exposure to their employer’s stock.
“Home bias” is when investors become overweight in their own market – having a disproportionate share of local assets compared to the global market.
It’s well documented and is seen across countries, asset types and both individual and professional investors – though the degree to which it occurs varies substantially.
Some home bias is expected for investors living in the world’s largest economies, such as the US. It can make sense to prefer investing in companies operating in countries with the strongest economic standing. This may explain US-centric portfolios even for investors outside America.
The puzzle of home bias
A range of behavioural explanations are typically given for home bias. A key one stems from the desire for familiarity. Familiar assets are seen as less risky and it can give a feeling of control; we feel we can influence the outcome.
Investors, too, very often perceive themselves as more competent about assessing domestic assets and overestimate their judgements.
Conversely, investors perceive more risk to investing abroad than is deserved – simply because overseas companies are understood less.
Then there’s “ambiguity aversion”, another bias where investors will lean towards known outcomes over unknown ones. This can also breed home bias.
Another explanation relates to foreign currency exchange risk and transaction costs. Many investors invest locally to trade in their home currency and avoid hedging currency exposure. While trading foreign equities can bring higher costs. Exhibiting a home bias may be seen as hedging against this additional uncertainty.
The cost of familiarity
While a home-biased portfolio may provide an investor with a sense of comfort, it can limit financial returns and ratchet up risk.
Home-biased investors will be left overly exposed to the specific risks inherent to that particular country or region. The more you spread your portfolio across geographic regions, the less likely you are to suffer at the hands of one localised market shock.
Risk of lower performance
By overly concentrating on one region versus others, an investor can also miss out on particular sectors that play an important role in economic growth. For example, the FTSE 100 lacks the large technology component of US indices, which have driven stock market valuations in the latter to record highs in recent times (albeit this is, of course, no guarantee of future performance).
Our perceived knowledge and experience of our home region is independent of the factors driving its performance, or that of regions that an investor may overlook or underweight. If the region we focus on performs well, but underperforms relative to others, an investor will not maximise their returns.
There’s a bigger world out there
So, what’s the implication for investors?
While having over- or under-exposure to a region may boost returns for some time, for reasons specific to that time period (which are likely to be clear only with hindsight), this is unlikely to be in the best interests of long-term investors.
It’s why we believe a diversified portfolio provides the building blocks for a higher probability of investing success over the long term. And while diversification is frequently discussed in relation to asset classes, it also applies to investment locations. Given that international markets rarely move in the same direction at the same time, a period of lower returns in one region can be offset by outperformance of others in the portfolio.
Focus on the outcome
Investors have a balance to strike between the comfort provided by a home-biased portfolio and potentially more profitable investments which they are less familiar with. This can also extend to factors such asset classes and financial instruments.
Familiarity and emotional comfort may make the investment journey more enjoyable in the short term. However, it is the outcome over the long term that is most important.
Arguably an investor’s key concern is whether they are utilising all of the tools at their disposal to have the best chances of reaching their financial goals.
Regularly reviewing your existing portfolio and speaking to your advisor about whether you are best positioned to meet your goals, seems to be a sensible first step for this.