Beware of being invested too close to home

Key points:

1. Behavioural biases are common when making investment decisions and can be worse in periods of extreme market volatility. 
2. Many investors tend to prefer investing in stocks and bonds from their home country than to venture overseas. This can be due to familiarity with the names or a belief that investing overseas is riskier.
3. UK equity investors are thought to have around 25% of portfolios invested at home, while the value of UK stocks is worth just 4% of the global market. 
4. Being overly exposed to one country, or asset, in a portfolio can be dangerous. For instance, UK investors with a home bias would have underperformed a globally diversified strategy in the last decade.
5. Gaining exposure to a range of countries is key to building a diversified portfolio. In doing so, attention should be paid to a company’s business model.

Recent troubles in the banking sector, such as the collapse of Credit Suisse, triggered a spike in financial market volatility, in turn highlighting the importance of diversifying a portfolio. 

It’s one thing buying local produce when stocking up on groceries. It’s another focusing too much on domestic stocks when investing in a portfolio. 

Many investors tend to prefer investing in local equities and bonds given that they are probably familiar with them and understand what they do. Along with a tendency to have more belief in domestic assets over others, this can lead to a portfolio that is home biased. However, such a strategy can hurt long-term performance. 

Beware of too much home bias

Investment decisions are affected by people’s behavioural biases to varying degrees. Indeed, such biases can be more pronounced when investing overseas. 

Home bias in UK equities is thought to be around 25%¹, despite them being worth just 4% of the value of stock markets globally. This varies between countries and can be seen to an even greater extent elsewhere.

A feeling of being more familiar with local businesses than overseas ones is one of the biggest drivers of this behaviour. Additionally, many investors might believe it is riskier to invest in overseas companies, even though including them in a portfolio can reduce risk.  Many believe they can better assess domestic assets in comparison to non-domestic ones, and may over-estimate their judgements.

Perhaps a more justified reason for focusing on investing locally is the exchange rate risk of investing in another currency, and in turn avoiding the question over whether to hedge currency exposure or not. As such, a home bias might be seen as avoiding additional uncertainty.

A joined-up world

While recent geopolitical tensions, like those between the US and China, may point towards a more fractured world, trade continues to flow around the globe. Integrated supply chains and multinational customer bases help businesses, wherever they are listed, earn revenues outside of their home country. That said, political concerns in some regions may discourage some investors from allocating funds to such locations.

However, the diverse structure of many companies means that it can still be possible to make good investments in troubled regions, irrespective of those factors. For example, we recently discussed investment opportunities in UK equities, despite a relatively weak economic growth outlook and last year’s political tensions.

What about portfolio performance?

Home bias can create heavy exposure to certain currencies and sectors. Overly concentrating investments in only a few areas will probably add to portfolio risk and could hit long-term returns. 

For instance, if we look at the last two decades from March 2003 to March 2023, a stronger UK home bias would have led to lower risk-adjusted returns. This has happened partly due to the FTSE 100 underperforming relative to markets globally, as measured by the MSCI World index, and sterling’s loss of value against the US dollar over that time.

In general, the fewer the number of securities in a local stock market that is being over-weighted, the bigger the potential impact on portfolio risk and return.

The attractions of being diversified

The country in which a security is listed should not be the main driver of the decision to include it in a portfolio or not. Gaining exposure to a range of countries is an important part of building a diversified portfolio. In doing so, attention should be paid to a company’s geographical reach, such as the countries in which its customers are based and the location of its suppliers, rather than which nation it is listed in.

Being over- or under-exposed to a region may lift returns for some time, probably for reasons that only become clear in hindsight. However, this does not form the basis of a proper long-term investing strategy.

A portfolio that is diversified, whether by country or asset, is more likely to form the basis for sustained investing success. Because international markets rarely move in lockstep, as some regions underperform the wider market, others will overperform, helping to diversify a portfolio and target better risk-adjusted returns.

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