“I like what I know and I know what I like”
This in essence is home country bias, a phenomenon that can be seriously detrimental to investment performance.
A more precise definition of home country bias is that it occurs when investors concentrate their portfolios in shares and bonds from their home country at the expense of global diversification.
For example, while the UK stock market represents only 7% of the value of global equity markets, many British investors tend to allocate considerably more of their equity assets to UK stocks.
As you can see from the chart below from Vanguard, it is not a problem that is unique to the UK.
From my experience, I have found that investors from most other countries, for example France and Spain (3% and 1% of the global stock market respectively), are also exposed the this bias.
What causes home country bias?
Whether consciously or not, investors tend to tilt their portfolios towards their home country. This typically happens due to one or more of a number of reasons:
* Familiarity – We like to invest in things that we know. With so much uncertainty (Brexit, Trump, who is going to win “I’m a celebrity…” etc.) it is understandable that investors may not want to wander too far from home.
In investing, what is comfortable is rarely profitable.
-Rob Arnott , founder and Chairman of Research Affiliates
* Perception of risk – Due to factors such as corporate governance, investors perceive foreign investments as more risky than domestic ones.
* Currency risk – The return on foreign investments may be impacted by fluctuations in exchange rates.
* Personal experience – I have known clients invest in a company because a friend or family member works there and they feel that this gives them an insight into the health of the company; we are less likely to have friends/family members working for a company in a country other than our own.
* Employer pensions and share ownership plans – Many employer pension schemes will typically be heavily weighted towards domestic stocks, e.g. a UK pension will typically invest in UK stocks, a Canadian pension in Canadian stocks etc.
Then there are employer share ownership schemes. Even as expatriates, we often work for a company from our home country. Accumulating stock in them as part of your remuneration package increases your home country bias (the danger of being over exposed to shares in your employer is a subject for another day).
* Multinational companies – Some investors rely on investing in domestic companies with a global presence as a means of diversification. However, while multinational domestic companies do provide exposure to global markets, it is not the same as investing directly into those markets. In fact, research from Vanguard suggests that the performance of a company’s shares tends to be highly correlated to its domestic market, irrespective of where it does most of its business.
Why does it matter?
As mentioned at the outset, home country bias at a minimum can be detrimental to an investment strategy and can often be far more damaging.
In fact, it has been shown that by avoiding broad global diversification, investors are actually increasing their risks. This is because, in general, individual country markets are much less diversified than the global market.
The UK FTSE All-Share Index contains 636 companies, with the ten largest accounting for nearly 35% of the index.
By comparison, the global index is made up of 14,447 companies, with the top ten making up only 7.9%.
The global index also gives you access to companies from 46 different countries.
Source: Vanguard UK
Instead, academic research strongly suggests that the foundation for long term investment growth is a globally diversified portfolio.
As the chart below shows, in the 20 years through to the end of 2016, 13 different developed countries (out of 21) had the best performing stock market for a given calendar year.
In addition, no one country had the best performing market for more than two straight years.
This just goes to show the power of diversification and not being overly reliant on one particular country (e.g. your home country).
Equity returns of developed markets
There is also the fact that different markets arbitrarily tilt towards different sectors. The U.S. for example has a high weighting towards technology stocks whereas the UK leans more towards financial firms and Canada has a predominance of mining and resource companies.
These sectors do not all move in the same way and if, for example, you are biased towards the UK and financial stocks perform poorly, then your portfolio will lag the global market.
It is hard to predict which sector will perform well over any time frame and simply owning them all reduces the risk of being overexposed to one.
What to do about it?
Many investors simply aren’t aware that they are overexposed to their home country. So the first step should be to drill down into the individual funds that you hold to identify the underlying assets that are held within.
Once you know the weighting that you have to your home country, you can compare it to your country’s share of the world stock market to see if it is out of proportion.
World equity market capitalisation
Source: Dimensional Fund Advisers
The simplest solution if you do suffer from home country bias is to reinvest across all markets in proportion to their share of the overall world market (a global market-cap-weighted index fund would achieve this).
In doing so, you own the whole haystack instead of searching for the needle within.
For investors who have a crystal ball, portfolio diversification is unnecessary. For the rest of us a globally diversified portfolio tended to on a regular basis provides an opportunity to better handle the vagaries of volatile markets…
Abnormal Returns www.abnormalreturns.com
By falling foul of home country bias, you may miss out on global opportunities as well as incurring a greater concentration of risk in your portfolio.
Instead, by building a broadly diversified portfolio instead, you can reduce both the volatility of your returns and the risk of being overexpose to a specific country or sector.