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In prior newsletters we have mentioned about common mistakes that most investors do. One such mistake that is prevalent in almost all countries (some much more than others) is the ‘Home Biased Investment Portfolios ’ which means that investors over the world over-weigh their own country stocks in their portfolios, in some cases to the extreme as shown below in the research.

But why should we care and what is the difference?

First, one of the only ‘free lunches’ in investment is: Diversification, that is, spreading your assets into different asset classes, regions, companies and such, so that you can lower the volatility (the up & down swings to your portfolio) while enhancing long-term performance. Dozens or more of long-term researches verify the benefits of diversification and now it’s considered one of the cardinal rules of investing. By overweighting your own country, just because you feel familiar, you are violating this cardinal rule.

Second, by overweighting your own country you are opening yourself to unnecessary risks (that can be avoided) related specifically to that country’s geopolitics or economy. If something happens that affects the country as a whole, all companies in the country will suffer, even though you may be diversified within different companies in the country.

Third, many that invest domestically also invest in sectors that they may know or feel familiar with, thus, further concentrating their risk to an unexpected event to that particular industry. An example is the tech people putting too much money in their sector and losing the most during the dot-com bubble in US. Similar scenarios can be thought for other professions and their own industries.

We also wanted to share the below research with you, as we believe that home bias investing is a major mistake that is preventing most from reaching their optimal performance with their investments. Diversification Works, and as such, investing much more money inside the country just because it feels good or familiar, is the Wrong Strategy. More data from Betterment Research below.

“Home (Bias), Sweet Home (Bias)

One of the most common mistakes individual investors make is over-weighting their portfolio to be “close to home”. It’s impressive how consistent that can be, across countries, states, and even counties.

It’s a general principal of wealth management that you should try to diversify risk away as much as possible. A very straightforward example is that if you work for a specific company (say, Enron), you should actually underweight Enron stock in your portfolio, along with other companies like Enron. This becomes apparent when there’s a generalized downturn in an industry, and employees lose both their jobs, and their wealth. Smart investors actually hedge away (or buy something like a put option) on their own company to reduce this risk.


Huw Aaron


Globally, individual investors are far more likely to have the vast majority of equity in their own country. In the tiny Philippines, with 0.1% of the markets global equity portfolio, individual investors hold 99.5% of their portfolios in Phillipino companies. In the UK, with 7.3% of global equity market capitalization, individual investors hold 65% of their portfolios in UK companies. And here in the US where we have 40% of the world’s equity capitalization we tend to have twice that – 82% – in domestic equity. And this is definitely sub-optimal.[1] The degree of home bias has not yet been explained by any good normative reason yet. Currency risk, better information, or capital immobility can’t actually solve this riddle.


Home Bias in International Portfolios (Betterment)

What’s funny is that this same bias appears on even a more local level. The preference for investing “close to home” also applies to domestic stocks. U.S. investment managers strongly overweight locally headquartered firms in their portfolios – particularly small, highly leveraged firms that produce nontradable goods.[2]

So why do we overweight our own countries’ portfolios? It makes us feel good to invest close to home. We know the company names, are comfortable with them, and (feel like…) we have more information about them. Countries characterized by higher uncertainty avoidance behavior display greater home bias and are less diversified in their foreign holdings. Portfolios from countries with higher levels of long-term orientation display lower levels of home bias.[3]

So what should you do?

“Invest in a simple international segment of your portfolio (like Betterment does), possibly a bit overweight non-US equities if you are a US investor. But keep it simple, diversified and long-term – many behavioral biases are likely to be worse with companies you’re less familiar with.”

[1] All data from Sercu, P. and Vanpee, R. (2007). Home Bias in International Equity Portfolios: a Review. Working Paper.
[2] Coval, J. D., & Moskowitz, T. J. (1999). Home Bias at Home: Local Equity Preference in Domestic Portfolios. Journal of Finance, 54(6), 2045-2073. Blackwell Publishing for the American Finance Association
[3] Anderson, C. W., Fedenia, M., Hirschey, M., & Skiba, H. (2011). Cultural influences on home bias and international diversification by institutional investors. Journal of Banking & Finance, 35(4), 916-934

Sincerely,

Patrick Volk
Lead Advisor, InvestEd.

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