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Beware the urge to bias investments too close to home

06 August 2021

By Alexander Joshi, London UK, Behavioural Finance Specialist

You’ll find a short briefing below. To read the full article, please select the ‘full article’ tab.

  • Summary
    • Investors may be more comfortable investing in local markets, but you’re more likely to maximise your returns if you explore further afield – through the benefits of diversification
    • Home bias stems from factors such as familiarity and emotional comfort, as well as avoiding foreign exchange risk
    • However, having a broad mix of investments with exposure to many countries and regions can boost returns while reducing portfolio risk
    • A regular review of your investment portfolio can be one way to properly diversify your investments and limit home bias.
  • Full article

    While investors may be more comfortable investing locally than exploring opportunities further afield, internationally diversified portfolios are more likely to maximise investment returns over the long run.

    European attractions

    We believe there are many reasons for investors to have exposure to Europe in portfolios. The potential benefits to investors of adding European equity exposure, where they may not have had much in the past, involve:

    1. diversification away from the US, where many investors are anchored;
    2. the ability to gain exposure to high-quality mid-to-large capitalised stocks, versus the mega-cap companies that dominate the US market; and
    3. less demanding valuations.

    There's no place like home

    European investors may require little convincing to add local exposure to a portfolio. After all, their home market tends to be the most familiar one.

    However, a common finding is that investors over-invest in their home market due to a preference for domestic equities, and/or a concentrated exposure to their employer’s stock. This is known as home bias, where investors overweight their own market and so invest disproportionally more in assets locally compared to their share in the global market.

    Home bias has been 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 the countries with the strongest economic standing. This may explain US-centric portfolios even for investors outside America.

    Home bias explained

    Why do many investors exhibit home bias? A range of explanations are typically given, including a general optimism for, and strong belief in, domestic assets, ambiguity aversion, perceived competence and past experience, foreign currency risk and transaction costs. We tackle these below.

    A key behavioural explanation stems from the desire for familiarity. Familiarity can give us a feeling of control; we feel we can influence the outcome. Investors may perceive an information asymmetry concerning foreign-based companies, attaching more risk to investing abroad than is deserved simply because overseas companies are understood less.

    There tends to be an aversion to ambiguity, and since most people are ambiguity-averse, this can breed home bias.

    Investors may also perceive themselves as more competent about assessing domestic assets and overestimate their judgements.

    Another reason relates to foreign currency exchange risk. Many investors invest locally to trade in their home currency and avoid hedging currency exposure. Exhibiting a home bias may be seen as hedging against additional uncertainty.

    Familiarity can cost

    While a home-biased portfolio may provide an investor with comfort, it risks limiting financial returns and lifting portfolio risk.

    Much of the reason that many investors prefer local assets that they are familiar with is the feeling of control over the outcomes. In other words, investing in these assets is seen as less risky.

    However, a home-biased portfolio can do the opposite. The investor will be overly exposed to the specific risks inherent to that particular country or region. Having a portfolio that is overly concentrated in a particular region increases the risk in a portfolio relative to one with a wider geographical spread.

    Risk of lower performance

    By overly concentrating on one region versus others an investor can miss out on particular sectors that play an important role in economic growth. For example, European indexes lack the large technology component of US peers, which have driven stock market valuations in the latter to record highs.

    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 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 (which are likely to be clear only with hindsight), this is unlikely to be in the best interest of long-term investors.

    We believe a diversified portfolio provides the best building blocks for sustained investing success. While diversification is frequently discussed in relation to asset classes, this also applies to investment locations. Because international markets rarely move in the same direction at 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. However, it is the outcome at the end of that journey 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.

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Market Perspectives August 2021

Financial markets remain in upbeat mood despite rising inflationary pressures and the increase in coronavirus cases due to the Delta variant.

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