I am sure many of you reading this are enjoying watching the World Cup, especially for those of you who are Croatian, English, French or Belgium!
The passion and patriotism on display is all well and good, provided it doesn’t overboard, but having a `home country bias` in investing can cost you dearly.
Humans are emotional and not rational beings, and as mentioned on this website before, the research indicates people try to avoid losses more than achieve gains, and can’t always differentiate between stability and volatility. This can cost you dearly long-term.
Vanguard produced some recent research and found that “when building portfolios, market-capitalization-weighted global indexes are a valuable starting point for all investors. Yet we find that many investors tilt their portfolios away from market cap, either consciously or unconsciously. Perhaps the most prominent tilt investors make is toward a home bias. To the extent this is an unconscious choice, we provide a framework for considering the benefits of global diversification”.
In plane English, the US Stock Markets represents about 50% of the world cap. The UK has a market cap of about 10%. Therefore, even as a British person, it makes no sense for me to have 65% or more in British markets.
Brinson, Hood, and Beebower 1986 paper is often considered seminar work in diversification. That paper showed that diversification is the primary driven of returns. The work by Vangaurd, 30+ years later, shows the data hasn’t changed.
Their data covers the United States, Canada, the United Kingdom, Australia, and Japan from January 1990 to September 2015.
The home country bias is clear:
What could contribute to the home country bias? Vanguard’s data and others indicate the following reasons:
1. Expectations. In one of the earliest studies on the topic, French and Poterba (1991) identified investors’ expectations about future returns in their home market as a key driver.
2. Preference for the familiar. Investors generally feel more comfortable with their home market and allocate investments accordingly, even if it results in a poorer risk/return trade-off for their portfolio. For example, Strong and Xu (2003) showed that investors tend to be more optimistic about their domestic economies than foreign investors are.
3. Corporate governance. Dahlquist et al. (2002) suggested that corporate governance practices have a major impact. High costs to access foreign securities may also encourage greater domestic investment.
4. Multinational companies. Investors may feel that through investment in multinational companies, they will attain as much global diversification as they will need.
5. Currency. Many investors perceive foreign investments as inherently more risky than domestic holdings. For example, it is not uncommon to see investment providers’ websites or literature list foreign equities among the riskiest assets, despite the well- documented diversification benefits of including foreign securities in a diversified portfolio.
Home country bias goes beyond investing. It applies to buying houses as well. Japanese investors have lost out big time by having a home market bias, and Canadians, Australian and Brits have also lost out compared to having a bigger allocation to the US.
The same thing applies for emerging markets. As the previous article states, diversifying into emerging markets is much more profitable than picking certain sections.
It might make sense to have a slightly higher allocation to your home markets than the market cap, especially if you are retiring there, but the above home market bias’ can’t be rationally justified.
Next time you top up your portfolio and rebalance, it might just be a good idea to alter your asset allocation. Investing isn’t the same thing as having a preference for your country’s food or football team. Nationalism or fear of the unknown really can cost you.