Most investors tend to exhibit certain trends when they invest and one of the most observable ones is home country bias. Home country bias is when an investor is over exposed to domestic equities in their investment portfolios. Let’s look at how this happens, the pros, cons, and how to resolve this.
How does home country bias happen?
In the past home country bias might happen due to investors not having easy access to information about other countries. But now days there’s a wealth of information about each and every country out there as well as the stocks available in each country. However, even with all the other information out their investors still exhibit a desire to own stocks within their own country and they own them in greater proportions than foreign stocks. This could be because of a variety of reasons, and at least for American investors, it’s likely recency bias of the last 10 years coloring their views. However, a study form vanguard pointed out that older investors show the most home country bias, where as younger investors tend to have more international exposure.
Source: How America invests 2020, Vanguard
Further, one more reason for home country bias is an emotional connection to invest in companies that you see every day. Perhaps investors like to invest in companies that they use and know their product well as opposed to leaving their choices up to a market cap weighted index fund.
The pros of biasing your home:
Avoiding currency risk
Where you live, you have to spend your money locally. When investing in companies internationally, you first have to convert your money into the foreign currency in order to invest – and if you buy an index fund this is done for you. And depending upon the timing of the buying and selling, you could potentially end up at a loss due to exchange rates moving against you. Although, there is some discussion about how big of a risk this really is and if hedging is all that important. Most fund managers will tell you this is important and you should hedge for currency risk, but generally there’s an almost zero expected return from currency risk. Meaning, you likely won’t gain but you likely won’t lose if you hedge or don’t hedge. If hedging makes an investor more comfortable, then they should hedge. However, pay attention to the fees and if a hedged index fund charges more, go with the unhedged version. But all else equal, one should be indifferent to hedging.
Possible tax advantages:
Some states and countries offer tax benefits to investors who keep assets within their own country. This can be helpful for dividend investors because dividends are sometimes taxed at different rates if the company issuing the dividend is domestically or internationally domiciled.
Even though globalization has increased our inner-connectedness between countries, the result is slightly higher correlations between countries. However, there’s still many countries with some or low correlation to each other. The below chart gives us an idea of the correlations between countries. The below chart illustrates how other countries index funds move with American index funds.
Even though in recent recessions we’ve seen they correlate highly with each other across markets and countries. The great recession and Covid-19 recession also had high correlations with other markets as it was a global event.
Cons of home country bias:
Under performance during some periods:
Further, with increased diversification across countries we can whether against periods of low home country growth. For example, if we take a look at the lost decade within America, we see very poor returns at 0.32%. However, if we had a more diversified portfolio, similar to VT (55% American and 45% international). The rate of return would have beat a solely American strategy with around a 1.64% return. Or if an investor decided to not invest in America at all during 2000-2011 they would have had a 3.06% return by not allocating anything to American index funds.
Source: portfoliovisualizer.com – portfolio 1 – 100% S&P500, Portfolio 2 – 55% S&P500, 45% International, Portfolio 3 – 100% international
Diversification across sectors:
Depending upon the size of your local country, not every part of a well-diversified portfolio may even exist within your country – or it maybe a tiny portion of your country well below a normal global market cap weighted index fund. You maybe opening yourself to further risk by being overweighted in a industry you did not expect.
Like index funds in Italy have no real estate in them. Where as for the US market we have a market weight of 3.43%.
Diversifying against your human capital:
In general, if you are working and earning income it generally comes from one country, your home country. It makes sense to diversify into a broad-based index fund because your most valuable asset – you – is tied up in largely the domestic economy. As immigration is difficult. It makes little sense for any investor really to tie up their entire retirement and portfolio into one geographical area. Even if our world is increasingly interconnected. The majority of us are still impacted heavily by local markets. Along these lines we argue that diversifying against home bias is a safer bet.
When you are investing both your portfolio and human capital into a single country, you’re over investing yourself and over exposing yourself to one countries risk. Your human capital growth is limited, in part, by how well your country does. Why limit your portfolio to the same risks? The worst case is when we lose our jobs due to poor economic conditions (destroying human capital) only to see that our portfolio (financial capital) has fallen for the same reasons. If you are not a pro stock picker, as Warren Buffett says, then over diversifying is your best bet.
If you’re just starting out and wondering how to get a broad-based diversification in your portfolio check out the easiest funds for the most diversification. But generally reducing home country bias reduces the risks you incur. And if you aren’t sure of how much risk you’d like follow this link. There’s a lot of global stock index funds out there if you’re wishing to get a broader, and more diversified portfolio I’d urge you to diversify into both index funds and into global market index funds as being undiversified is often costly to most investors. If you aren’t investing in the markets yet try using m1 finance (you’ll get an extra $10 dollars with the referral link) it’s a great platform for long term investing. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
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