Home bias in investing
Behavioral New World
November 1, 2021
Home bias in investing
“There’s no place like home”—Dorothy in The Wizard of Oz.
What is home bias in investing?
When we look at the portfolios of investors, we find that they concentrate their investments (e.g., stocks and bonds) in their home country. For example, U.S. investors tend to invest almost exclusively in U.S. companies.
Why is home bias detrimental to financial well-being?
Answer in brief: it leaves untapped the benefits of diversification.
Although there is mathematics to back up the benefits of diversification, diversification is common sense. You’ve probably all heard the phrase, “Don’t put all your eggs in one basket.” Diversification is not putting all your eggs in one country basket. By diversifying, you can gain risk reduction without a reduction in expected return.
Consider a simple thought experiment involving two countries. Suppose that when Home Country’s stock market goes up, Foreign Country’s stock market tends to go down, and vice versa. If you have a portfolio invested in both countries, the zigging of Home Country’s market is partially offset by the zagging of Foreign Country’s market. Your portfolio will have less overall risk than if you invested in just one of the countries.
More realistically, markets in different countries can be thought of as moving independently (not in opposition, as in the thought experiment) of one another. However, the mathematics of diversification shows that there are still significant benefits from diversification in this setting. Diversification is the closest thing to a “free lunch” as there is in financial markets.
Let’s consider a concrete, admittedly extreme, example--Enron. You might recall that Enron was a high-flying company that turned out to be largely fraudulent. It went bankrupt and its employees lost their jobs. Even worse, the employees had invested their retirement savings in Enron stock. They had much of their wealth in the Enron basket.
So when Enron went bankrupt, they not only lost their paychecks but also their retirement savings. No zigging and zagging here, just zagging and zagging (or zigging and zigging, if you prefer). For cocktail party chatter: “Their human capital was highly correlated with their investment portfolios.”
We can carry the diversification logic further. The case can be made for holding zero home-country stocks and bonds. Why? Because your paycheck depends in part on the economic health of your home country. So when it zigs, you want you investment portfolio to zag (or at least not zig). Despite the logic, few investors, if any, invest in this manner.
Why does home bias exist?
There are several reasons that help explain the existence of home bias. First, there is the belief that overseas investing in inherently riskier than domestic investing. But that belief ignores the discussion above about the benefits of diversification. Yes, as a stand-alone investment, an overseas investment might be risky, but in the context of a well-diversified portfolio, it will reduce risk.
Second, you might believe that you can know more about home-country companies than foreign companies. This belief is probably true, but that knowledge has little or no value—few people can “beat the market,” even those who are well informed.
Third, it can be more costly to invest overseas. Certainly true, but mutual funds and ETFs (discussed in the next section) can substantially reduce the cost.
Fourth, something called “familiarity bias” makes us more comfortable with investing in companies with which we are familiar. And we are likely to be more familiar with companies in our home country.
What can be done about home bias?
As always, awareness is the first step. Having read this far, you are aware of home bias.
Internationally focused mutual funds and exchange-traded funds (ETFs) are vehicles for getting international diversification. But look closely before investing—many international funds still have substantial exposure to U.S. companies. Another factor to consider is the expense ratio of a mutual fund or ETF—these days there is no reason to pay high costs to gain exposure to international markets.
Dorothy might well be right in terms of where to live, but her preference for home is not good advice for investing. Notwithstanding the apparent lack of investment opportunities in the Land of Oz, there is no place like overseas for investing.