Overcoming home bias when investing

Key points

• Many people tend to invest in what they know – whether that be equities, bonds or currencies – ending up with a ‘home bias’ in their portfolios
• A home bias is driven by behavioural traits and happens when investors over-invest in familiar assets, potentially missing out on opportunities elsewhere
• Past experiences, avoiding investments held in a foreign currency and awareness with markets closer to home can all be powerful drivers of the tendency to home bias portfolio holdings
• The  troubles with Credit Suisse and Silicon Valley Bank in March illustrate the dangers of being too concentrated in one area of the market. By contrast, a well-diversified portfolio can help to grow risk-adjusted returns over the long run

Market commentary was dominated by discussions on the health of the global banking sector in March, which started with the collapse of a regional US bank (Silicon Valley Bank, or SVB) quickly followed by a rescue acquisition of a Swiss banking giant (Credit Suisse). It would be entirely understandable for investors to ask how this happened and seek to understand the risks of contagion.  

Recent troubles in the banking sector highlight the importance of diversification; starting from the (lack of) diversification in SVB’s client base, which probably exacerbated its troubles, to the importance of diversified portfolio holdings in the face of elevated market volatility.  

However, some investors maintain a strong preference towards what they know and understand, which can bias their portfolios towards particular types of companies, asset classes and regions.  

This, combined with a tendency to have a general optimism for, and belief in, domestic assets, can fuel a home bias, despite the fact that international diversification can typically be positive from a risk-return perspective.

What is home bias?

Home bias involves investors disproportionally allocating more to local assets compared to their share in the global market. It is seen to varying degrees across countries and asset types, and from both individual and professional investors. 

For example, in the UK, equity home bias has been estimated to be approximately 25% of an allocation¹, despite UK equities forming just 4% of the global index (see chart). These estimates vary greatly between countries.

Why do people prefer to stay home?

A key behavioural explanation for home bias is that such assets and markets tend to be more familiar, and give us a feeling of control over outcomes. Investors might attach more risk to investing abroad than is deserved simply because overseas companies are less understood.  

Another reason is our aversion to ambiguity; situations where probabilities are unknown. Past experience can also play a role; investors may think they are better at assessing domestic assets and consequently over-estimate their judgements. 

The risk of investing in another currency is also real. Many investors invest locally to trade in their home currency and avoid hedging currency exposure. As such, exhibiting a home bias may be seen as hedging against additional uncertainty. 

Geographical separation can exacerbate biases 

In challenging market environments investors’ focus becomes more short-term and behavioural biases might hit performance. Heightened emotions sometimes make it more challenging to stick to one’s long-term investment path.  

Behavioural biases affect all investors to varying degrees. But such biases can be exacerbated for those who are further away from their investments and advisers, as unwelcome market noise can influence views on markets and subsequent actions.

It's all about the companies

Many investors may think in terms of ‘the market’ and believe their wealth is tied to its gyrations. It is important to think about investments at a micro level; remember that a diversified portfolio invests in the stocks and bonds of individual companies. 

Furthermore, in today’s interconnected world, multinational companies have international supply chains and customers, and thus generate much of their revenues outside of the country in which they are listed. However, some investors might avoid investing in a particular country perhaps due to political concerns or growth prospects.  

Because of the interconnectedness of companies, this can mean that an investor might still make good investments in those regions, irrespective of those factors. For example, there are still opportunities to be found in the UK equity market, despite the weak growth prospects and recent political upheaval.

What's in your pocket?

One way to think about it is to consider your smartphone. For many it is one designed by a US company and listed on the US stock exchange, assembled in China, with many raw materials, such as rare earth minerals, coming from all over the world. Likewise with cars, which may have been built in Europe but, again, using components coming from around the world.  

These two examples of everyday products show the strength of two particular regions as well as the importance of a global exposure. Yet many users of these products may be averse to investing in those regions, due to them being less familiar or geographically distant.

Think about the potential effect on returns

Home bias will likely lead to heavy exposure to certain currencies and sectors in the economy. The implication of a higher concentration in a portfolio is increased risk, as well as a possible drag on returns. By being overly concentrated on one region versus another, an investor can miss out on particular sectors that play an important role in economic growth.   

Using the UK as an example, over the past two decades a stronger UK home bias would have resulted in lower risk adjusted returns, as measured by the Sharpe ratio of a global equity portfolio (see chart).

Lower risk-adjusted returns occurred partially because of the underperformance of the FTSE 100 relative to the MSCI World and partially because of the depreciation of sterling relative to the US dollar, with much of the variation occurring since 2014 (See As many global investors depart sterling, should you? to find out more about why the UK currency has been losing its role as a safe-haven currency). 

The risk-return implications of equity home bias are likely to be more significant the narrower the local stock market that an investor is over-weighting.  

Diversification

So, what is 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 that are likely to be clear only in hindsight, this is unlikely to be in the best interests of long-term investors.  

A diversified portfolio should provide the best building blocks for sustained investing success. While diversification is frequently discussed in relation to asset classes, it also applies to regions. Because 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 in others. 

The location of a stock’s listing should not be the primary driver for inclusion or exclusion in a portfolio. Geographical diversification is important, but this should be considered in relation to a company’s wider exposures, such as the location of their customer base and supply chain, rather than the location of their stock exchange.