The Pros And Cons Of Home Bias
Many investors tend to exhibit a strong preference for their domestic equities, despite the highly integrated nature of financial markets that nowadays offer widespread access to capital. This observed lack of international diversification is commonly referred to as home bias.
Failing to globally diversify your portfolio can be costly, but the persistence of home bias suggests that the familiarity of domestic markets adds an additional benefit, in the form of emotional comfort, not usually factored in by a theoretical framework. This concept is not novel: John Maynard Keynes, in 1934, stated that it is inefficient to place faith in stocks which one has “no reason for special confidence”.
Traditional financial theory states that an average investor should optimally hold domestic assets in proportion to their country’s share of world capitalisation. The segmented nature of capital markets means that investors have the ability to reduce exposure to specific risks by adding an appropriate allocation of foreign securities to their portfolio. As a result, the international diversification opportunities gained from holding assets with lower correlations are likely to lead to greater risk-adjusted returns. This concept is central to modern portfolio theory.
The internationally diversified portfolio also exhibits much lower annual volatility than the individual countries, thus evidencing the potential for risk reduction when investing in a range of global equities. While a home investor may, on average, achieve greater returns than an internationally diversified portfolio, it is likely that the global investor will attain better risk-adjusted returns over the same investment horizon.
Given that home bias is costly, the question remains as to why so few investors pursue a globally diversified approach to investing? Institutional-based explanations such as currency fluctuations, transaction costs, trade barriers and information asymmetries do not collectively explain the “persistent” nature of home bias.
Instead we need to consider behavioural aspects. Investors may a have tendency to shy away from foreign investments because their expected risk and returns are perceived with greater uncertainty than domestic assets, while they also often add a risk penalty. Our conclusion is that the home-country bias problem is likely to be driven by the behaviour of the individual rather than financial market trends.